Traditional finance axioms
Traditional finance is based on neoclassical economics. The theory assumes that individuals act rationally, are risk-averse, have perfect information, and focus on maximizing their personal utility at all times. Rational investors exhibit utility theory, meaning that they have a limited budget and will allocate money to goods in a way that maximizes their utility. Investors under traditional finance are rational or “rational economic men” (REM). Rational economic agents will follow a set of self-evident rules or axioms. These are the traditional finance axioms.
On this page, we discuss the four axioms a rational decision maker will follow.
Traditional finance axioms definition
The four rules are the following:
- Completeness assumes that individuals know their preferences and use them to choose between any two mutually exclusive alternatives. For example, if an individual can choose between A or B, they may prefer A over B or vice versa.
- Transitivity assumes individuals consistently apply their completeness rankings. Thus, if the individual prefers A over B and C over B, he should also favor C over A.
- Independence means that the rankings are additive and proportional. Suppose A and B are mutually exclusive choices where A is preferred over B. C is an additional choice that can be added and which yields positive utility. In that case, A + x(C) should be preferred over B + x(C), where x is some portion of C.
- Continuity assumes that utility indifference curves are continuous. This ensures that an unlimited number of combinations of A and B are possible. Suppose B is preferred to A and C is preferred to A, then there will be a combination of A and C that gives the individual the same utility as B.
These are the four axioms that ensure that economic agents behave rationally. While these rules are considered self-evident to some, behavioral finance asserts that these axioms are not true for the way most people act.
Summary
We discussed the four axioms of traditional finance. Taken together, these axioms ensure that investors behave rationally, focusing on maximizing their personal utility function. This kind of behavior should lead to efficient markets where prices reflect available, pertinent information. This is referred to as the efficient market hypothesis.