We congratulate Richard Thaler on winning this year's Nobel Prize in Economics. His relentless research on the failings of rational behavior in human decision-making has had a significant impact in finance and economics. His prolific work is the foundation for all of what we call behavioral economic and finance. Prior to Thaler, economist focused on Homo Economicus, the rational man that does not make mistakes or misjudgments. Thaler showed through test after test that we make mistakes and have biases. He did this albeit radical work not as an outsider to finance like Dan Kahneman but as a economist steeped in the neoclassical tradition.
Through an ever-increasing set of tests and analysis, Thaler showed us that investors do have inherent biases. Being human means making mistakes. There is now a catalogue of behavioral mistakes that can affect rational choice and market behavior. His work links economics and psychology and pulls economics closer to other social sciences and away from any view that it is like a hard science. Economics cannot be stripped of its psychological roots. There have now been three economists that have focused on this part of economic behavior, Dan Kahneman, Bob Shiller, and now Richard Thaler.
Why is this important to trend-following and quant trading? Thaler, with his work in the 80's, gave reason for why quant models could work. The behavioral finance revolution justifies the use of models to hard code good behavior. For example, we know that investors have a tendency to hold onto winner and sell losers. The behavior evidence is strong. Models can be built to offset this bias. Behavioral finance suggests that errors are made with a tendency to react slowly when faced uncertain risks. Trend-following, attached to risk management rules, can offset some of those errors.
More broadly, the behavioral finance revolution tells us that markets are not likely to be efficient, Prices may not move immediately to equilibrium given our cognitive biases. However, there is the potential for schemes to break through these behavior biases. Behavioral finance cannot tell us which models will make money or how to make money, but it does tell us that disciplined rules-based investing can protect investors and serve as a way to offset any bad behavior.