Traditional vs, Behavioral Finance Assumptions

I am reading the personality typing section from the 2010 CFA level 3 book2, reading 14 – Managing Individual Investor Portfolios, by Bronson, Scanlan, and Squires (BSS). Below I will quote some of their works with quotation marks or if none I will make obvious note. So far it’s been a very interesting reading – it briefly compares traditional finance assumption to the behavioral ones. My understanding is that traditional finance assumes rational investors (or more appropriately, the institutional investors) operate in a perfect market condition utilizing financial science to make investment decision, while the behavioral finance focus on individual investor’s investment making process which involves many psychological factors and which almost totally throw away the rational assumptions used in the traditional finance model. The two theories maybe are the complement to each other, covering the major investment decision making process happened to the human society. Financial advisors (institutional and individual) need to know both in order to be able to quickly gear the discussion with clients to the potential concern areas.
According to BSS, in traditional investment decision making, investors are assumed to “exhibit risk aversion, hold rational expectations, and practice asset integration.” However, behavioral finance assumes investors “exhibit loss aversion, hold biased expectations, and practice asset segregation.”
Risk aversion exhibited by rational investors means that they will look at standard deviation and talk about probability of loss at the end of investment horizon. They possess statistic like standard deviation and covariance because they use market information to predict future investment outcome and that they can accurate predict various economic variable like inflation rate, interest rate and real growth rate of GDP. Investors are like scientists in this model, gathering, analyzing and making investment decision objectively without emotional attachment.
Loss aversion exhibited by individual investors means that individual investor “opportunities in terms of gain or loss rather than in terms of uncertainty with respect to terminal wealth.” Human brain understands and calculates whole number quickly and effectively then fraction in conjunction with multiplication and division. I once heard a co-worker complained that his parents don’t understand standard deviation even after he tried explaining to them multiple times. The brain is not wired to think in terms of complex math and one need be trained to think in terms of financial math is my take away. OK we are jumping to psychology already, but it seems like psychology industry is still developing slowly in terms of their understanding of the human brain. Maybe due to legal and humanitarian consideration neuron study are progressing much slower than other fields like the finance and IT industry. Behavioral finance also points out that individual investor is no expert in terms of predicting economy future, that average individual investor won’t have the knowledge and tools to accurately estimate inflation, interest rate and GDP growth ex ante.
As a consequence of the different assumptions about investor’s behavior, the portfolio construction process is different under the two theories:
"• Traditional finance: (1) Asset pricing is driven by economic considerations such as production costs and prices of substitutes. (2) Portfolios are constructed holistically, reflecting covariances between assets and overall objectives and constraints.
• Behavioral finance: (1) Asset pricing reflects both economic considerations, such as production costs and prices of substitutes, and subjective individual considerations, such as tastes and fears. (2) Portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer reflects certain goals and constraints."