Daniel Kahneman, a psychologist at Princeton University, and Vernon Smith, an economist at George Mason University in Virginia, will share this year’s Nobel Prize for Economics. Both have done pioneering research into how real-world risk preferences produce outcomes not predicted by traditional financial theory.The Nobel Committee said Kahneman’s award recognises his role in integrating insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty, while Smith has “established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms".
Kahneman’s early work was fundamental to the development of behavioural finance, which seeks to integrate psychological factors into financial theory. In 1979, he co-developed prospect theory – a way of describing decisions made under uncertainty. His work demonstrated how humans are prone to making decisions using judgements inconsistent with the basic principles of probability. This was a marked departure from classical financial theory, much of which is underpinned by an implicit assumption of the perfect rationality of decisions.
At the vanguard of current research into how the psychology of traders affects their performance is Andrew Lo, director of the financial engineering laboratory at the Massachusetts Institute of Technology. He is currently studying the importance of emotion in the decision-making process of professional securities traders.
Lo, who was speaking at Borsa Italiana’s second annual hedge fund conference in Milan last week, said his study is focused on measuring physiological characteristics such as skin conductance and pulse rate during live trading sessions, while simultaneously capturing real-time prices from which market events can be detected.
He said preliminary results indicate a significant correlation between electro-dermal responses and transient market events, and between changes in cardiovascular variables and market volatility.
Lo also observed differences in these correlations among the different traders that may be systematically related to the traders' levels of experience. “Those traders that show strong emotional responses to the market appear to be more successful. This is in contrast to the stereotyped view of the cool, calm trader,” Lo said.
Nobel prize co-recipient Smith’s best-known research is in experimental economics. He has focused on how alternative markets such as auctions work, and also investigated how irrationality affects the efficiency and dynamics of stock markets. Kahneman and Smith will receive a total award of SKr10 million.
More on Economics
The surprise decision by the Federal Reserve last month not to scale back its quantitative easing programme will create more volatility, says economist
IMF chief economist says ‘three-speed’ global economy could be dangerous
Dealers will present their case as to why the ECB should buy linkers as well as nominal bonds in a conference call today
Sign up for Risk.net email alerts
Sponsored video: MarketAxess
Sponsored video: Tradeweb
Multifonds talks to Custody Risk on being nominated for the Post-Trade Technology Vendor of the Year at the Custody Risk Awards 2014
Sponsored webinar: IBM Risk Analytics
There are no comments submitted yet. Do you have an interesting opinion? Then be the first to post a comment.