This Is What The Nobel Prize-Winning Economic Theory Means For Traders

This year’s Nobel Prize-winning economist sits in no ivory tower.

The research of the University of Chicago’s Richard Thaler, regarding the fundamental humanness of finance and the irrational nature of decision-making, has directly influenced market practices.

“By exploring the consequences of limited rationality, social preferences, and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes,” the Royal Swedish Academy of Sciences said in its Monday announcement.

The Markets

In one sense, Thaler’s theories have informed trading strategies — the ways analysts and investors interpret and respond to market activity. They encouraged mindfulness of factors not obviously linked to economic participation, such as irrational biases, preference for loss aversion and tendencies to overreact.

They also inspired a new mindset for anticipating stock movement and reacting to major events.

“With regard to market activity, the question has shifted from ‘what are the facts’ to ‘what shall be the market’s reactions to the facts,’” Jean Ergas, chief economist at Tigress Financial, told Benzinga. “Following the concept of ‘once burned twice shy,’ investors may be slow to react to changed circumstances, [and] this may create under-valuations which may correct with a ‘step-function’ leap. With regard to trading, this may also extend to turning moments of ‘panic’ and scarce liquidity to snap up assets cheap [while the] rest of the market is trading on synchronized fear gauges.”

The Street’s early disbelief in Brexit, for example, presented opportunity to apply Thaler-esque trading theory, Ergas said.

Publicly Traded Companies

Behavioral economic theory has similarly impacted corporate strategy, which ultimately impacts market performance.

“[Thaler’s] work has encouraged governments and companies to make a greater effort to incorporate behavioral science, including elements related to unconscious biases, as well as comfortable but misleading rules of thumb and analytical shortcuts,” Mohamed El-Erian wrote in a recent Bloomberg post.

The Fintech Scene

The same principles have guided the development of numerous fintech companies. Trigger Finance prevents emotional, impulsive investing through the use of algorithms, while Matador capitalizes on social influence by allowing users to track the trading activity of “friends” and follow their lead.

Dream Forward intentionally leverages principles of behavioral economics and weaves Thaler’s theories into the fabric of its financial technology, a 401(k) service with an “emotional advisor.”

“We've built a conversational artificial intelligence designed to talk to users like a behavioral economics professor would,” co-founder Brendan Sweet said.

The roboadvisor responds changes in 401(k) strategy, questions user activity and guides them to make emotionally-detached decisions.

“It ... can deal with employees’ emotions and excuses,” Sweet said. “To borrow a term from Thaler, our A.I. tries to ‘nudge’ users in the right direction.”

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Posted In: Behavioral EconomicsDream ForwardJean ErgasMatadorMohamed El ErianRichard ThalerTigress FinancialTrigger FinanceEducationEconomicsExclusivesInterviewGeneral