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.