Influence of Emotions on Investment Decisions
Emotions play a significant role in investment decisions, affecting risk preferences and perceptions. Positive emotions lead to riskier choices, while negative emotions result in more risk-averse decisions. Emotions also impact beliefs, preferences, and financial evaluations, potentially causing biases in value estimates. Background feelings, like mood, influence financial decision-making, where a good mood fosters optimism and a bad mood leads to pessimism. Additionally, external factors such as sunshine can impact decision-making, with sunny days potentially correlating with higher market activity.
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Chapter 10 Emotion and Investment Decisions
Emotion and Feeling in Decision-Making Psychologists believe that emotion and feelings influence decisions. Consider two models: affect and heuristic Affect refers to subtle feelings Heuristic refers to mental shortcuts 2
Affect and Risk Aversion Subjects play a game in which they must continuously choose between a risky asset with known probabilities for each outcome and a risk-free asset They play for money Positive, neutral, or negative emotions are induced Results: Positive emotions leads to riskier choices and more confidence in those choices Negative emotions lead to more risk-averse choices 3 Camelia M. Kuhnen and Brian Knutson, The Influence of Affect on Beliefs, Preferences, and Financial Decisions, Journal of Financial and Quantitative Analysis 46(2011): 605 626
Feelings and Expectations If prices reflected a dividend discount model: PV = D1 / (k g) But your expectations become biased: E(P) = D1 / (k E(g)) Your estimate of value will be off by: ( ) E P k g = ( ) PV k E g E ( ) 12 4 8 E P k g = = = . 1 = 14 ( ) 12 5 7 PV k g 4
Emotion can also influence risk perceptions and cause similar mis-pricing: ) ( ) E P k ( g = PV E k g ( ) 12 4 8 E P k g = = = = . 0 80 ( ) 14 4 10 PV E k g 5
Misattribution Bias Financial decisions are complex and include risk and uncertainty Under these conditions, background feelings (or mood) will influence financial decisions A good mood causes more optimism in evaluating an investment A bad mood causes more pessimism and critical analysis 6
Misattributing Sunshine Sunshine puts us in a positive mood Tipping 50% higher on sunny days compared to rainy days What about stock markets? 7
Annualized Difference in Return Between Sunny Days and Gloomy Days 8 David Hirshleifer and Tyler Shumway, Good Day Sunshine: Stock Returns and the Weather, Journal of Finance58(2003): 1009 1032
Weather Professional investors can be impacted Examining their trades reveals: More critical of stock pricing during cloudy days Sunshine impacts an investor s level of risk aversion When risk aversion is high, an investor is more likely to sell stock (or at least not to buy) When risk tolerance is low, a person is more likely to buy stock When the weather is sunny, institutions have a greater propensity to buy stock Weather impacts risk tolerance, but not intellectual ability Sunshine puts people in a good mood and does not inhibit their ability to quantitatively assess choices good mood seems to bias them toward making decisions through optimism and lower risk aversion William N. Goetzmann, Dasol Kim, Alok Kumar, and Qin Wang, Weather-Induced Mood, Institutional Investors, and Stock Returns, Review of Financial Studies 28 (2015): 73 111. Anna Bassi, Riccardo Colacito, and Paolo Fulghieri, O Sole Mio: An Experimental Analysis of Weather and Risk Attitudes in Financial Decisions, Review of Financial Studies 26 (2013): 1824 1852. 9
Winter Blues, or S.A.D. (Seasonal Affective Disorder) People feel depressed as the amount of sunshine declines Stock returns are lower during the fall when daylight decreases until December 21 Occurs in Britain, Canada, Germany, Sweden, and United States Effect is in the spring for Australia and New Zealand 10
Negative Emotions Investors can misattribute the negative feelings from other factors in their environment When large groups of people have negative emotions, the stock market can be affected due to the increase in risk aversion Consider two cases: Lunar cycle Sports competitions 11
Lunar Cycle The moon has long been associated with mental disorder Lunacy links potential mental illness with the lunar cycle. Psychologists have reported correlations between the full moon depressed moods The returns in 48 stock markets around the world were investigated during the lunar cycle Stock returns were 3 5 percent lower per year during the seven days around the full moon than around a new moon. 12 Kathy Yuan, Lu Zheng, and Qiaoqiao Zhu, Are Investors Moonstruck? Lunar Phases and Stock Returns, Journal of Empirical Finance 13(2006): 1 23
Local Sports Team Loss Psychologists have found an increase in heart attacks, crimes, and suicides following sporting losses Stock returns in 39 countries to more than 1,100 soccer match outcomes The day after a loss, the losing team s stock market declines an average 0.21% ( 0.49% after a World Cup elimination game) Study local firms returns after NFL loss Firms in winning city outperform losing city firms by 0.0575% the day after the game (double for a playoff game) Alex Edmans, Diego Garcia, and Oyvind Norli, Sports Sentiment and Stock Returns, Journal of Finance 62(2007): 1967 1998, and Shao-Chi Chang, Sheng-Syan Chen, Robin K. Chou, and Yueh-Hsiang Lin, Local Sports Sentiment and Returns of Locally Headquartered Stocks: A Firm-level Analysis, Journal of Empirical Finance 19(2012): 309 318 13
Optimism: 3Coms spin-off of Palm One of the innovative products developed by 3com was the Palm Pilot. In 2000, 3Com decided to spin off its Palm subsidiary as an independent operating company. The plan was to issue 5% of the shares of Palm in an IPO and distribute the remaining 95% of the Palm shares to 3Com stockholders. On March 2, 2000, 3Com conducted the Palm IPO. The other 95% of the Palm stock was to be distributed later in the year as 1.5 shares of Palm for every 1 share of 3Com stock owned. 14 Continued
Optimism: 3Coms spin-off of Palm By the end of the Palm IPO day, newly issued shares of Palm traded at $95.06 per share. Since holders of one share of 3Com could expect to receive 1.5 shares of Palm in a few months, 3Com stock should have then been worth $142.59 (=1.5 x $95.06) plus the value of 3com s other operations. 3Com s stock price should have been substantially higher than $142.59. 3Com stock closed at only $81.81 per share, or at roughly 57.3% of the value of the company s shareholdings in Palm alone, not to mention the value of 3Com s other operations! 15
Ramadan and Fasting Ramadan is a time for fasting, reflection, self-reformation, giving, worship, social awareness, and a closer relationship with fellow Muslims around the world This enhances their satisfaction with life and encourages optimistic beliefs A study examines the stock market performance in 14 Muslim countries around Ramadan. The results show that stock returns during Ramadan are significantly higher and less volatile than during the rest of the year. 16 J drzejBia kowski, Ahmad etebari, and Tomasz Piortr Wisniewski, Fast Profits: Investor Sentiment and Stock Returns during Ramadan, Journal of Banking and Finance 36(2012): 835 845
Pessimism of the general population through the photos Photos from Wall Street Journal Process examines thousands of photos that have been classified as pessimistic/optimistic by people. Then the algorithm learns the traits that separates these mood extremes and applies them to the news photo sample. Photo Pessimism index Index negatively predicts the next day s market returns, which reverses over the remaining 17 Khaled Obaid and Kuntara Pukthuanthong, A picture is worth a thousand words: Measuring investor sentiment by combining machine learning and photos from news, Journal of Financial Economics, forthcoming 2022.
Sentiment After periods of high optimism (positive sentiment), stock prices are high and thus may not offer very good returns in the future. After periods of high pessimism (negative sentiment), stock prices are low and thus may offer good returns. 18 Malcolm Baker and Jeffrey Wurgler, Investor Sentiment and the Cross-Section of Stock Returns, Journal of Finance 61(2006): 1645 1680
Music Sentiment People reflect their mood in their music choices Study created a music-based sentiment in 40 countries and assessed its association with each country s equity market Spotify provides daily statistics of the top-200 songs by the total number of streams in each country An algorithm classifies a song s valence, or positivity They find a positive and significant relation between music sentiment and concurrent market returns A one-standard-deviation increase in music sentiment is associated with a higher weekly return of 8.1 basis points, or 4.3% annualized The study also shows that music sentiment predicts increases in net mutual fund flows and decreases in government bond returns 19 Alex Edmans, Adrian Fernandez-Perez, Alexandre Garel, and Ivan Indriawan, Music sentiment and stock returns around the world, Journal of Financial Economics, forthcoming 2022.
Bubbles Japanese stock bubble. Nasdaq-Tech bubble. Housing bubble. Credit bubble. One of the most impressive market bubbles occurred in Holland in the 1630s, with tulip bulbs Over a five-year period, the mania inflated prices to the point where one bulb was worth 10 times a yoke of oxen. A tulip bulb cost nearly $100,000!
Stock Bubbles From January 2, 1985, at 11,543, the Japanese Nikkei 225 soared to a closing high of 38,916 on December 29, 1989. This represents a gain of 237.1% in the Nikkei over a 5-year period, and a stunning 27.5% compound annual rate of return. Then, the bubble burst and the bottom fell out of the Japanese equity market. Fifteen years after the Japanese market peak, in December, 2004, the Nikkei stood at 10,796. That s 72.3% below the December, 1989 peak. From a (split-adjusted) level of 125 on January 31, 1985, the Nasdaq 100 soared to 4,816.35 on March 24, 2000. This represents a 15 1/4-year return of 3,753.3%, and an amazing compound return of 27.1% per year. The Nasdaq plunged, losing over 80% of its value by 2002. 21
Peak Positive Mood Declining Mood Increasing Mood Peak Negative Mood Emotional Characteristics at Each Phase of the Social Mood Cycle Increasing Mood Declining Mood Peak Positive Mood Peak Negative Mood Optimism Overconfidence Pessimism Fear Happiness Euphoria Sadness Depression Generous Excess Conservatism Stinginess Inclusion Ambivalence Exclusion Segregation Supportiveness Graciousness Defensiveness Antagonistic Hope Trust Suspicion Mistrust 22
Investing For Fun! Some people may buy and sell stocks for the thrill of it People who enjoy gambling, also do more stock trading One study merged brokerage account data with other Finnish national databases to study sensation seeking and trading: People who get speeding tickets trade more People who scored higher in sensation seeking on psychology tests (during mandatory military service) traded more 23 Mark Grinblatt and Matti Keloharju, Sensation Seeking, Overconfidence, and Trading Activity, Journal of Finance 64(2009): 549 578
Summary Emotions are an important part of the decision-making process. This is especially true for decisions that involve a high degree of uncertainty, such as investment decisions. Sometimes, emotion can overcome logic in this process. Too much optimism leads investors to underestimate risk and overestimate expected performance. Pessimistic investors tend to be more analytical. Extended, extreme optimism can cause price bubbles. Sensation-seeking investors look for the gambling-like emotions from excessive trading. 24
