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Optimism, volatility and decision-making in stock markets

Rocciolo, F., Gheno, A. and Brooks, C. (2019) Optimism, volatility and decision-making in stock markets. International Review of Financial Analysis. ISSN 1057-5219 (In Press)

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To link to this item DOI: 10.1016/j.irfa.2019.05.007

Abstract/Summary

In this paper we introduce a new, analytically tractable framework for decision-making under risk in which psychological characteristics related to the degree of optimism or pessimism of the decision-maker are considered. The framework we propose, which is based on a two-parameter optimism weighting function, is applicable to a wide range of decision-making models and renders even the simplest, such as expected utility theory, able to describe the behavior of decision-makers within a more parsimonious frame- work. In particular, the optimism weighting function that we introduce is formalized as a function of the volatility of the lotteries faced. This simplifies applications of the framework to financial decision-making problems. For the purpose of demonstrating this applicability, we also derive an extension to a well-known asset pricing model to elicit a measure of market sentiment in the U.S. stock market. The results lend support to the relevance of the degree of optimism, both in financial decision-making problems and in the expectations that agents have of excess returns in the market.

Item Type:Article
Refereed:Yes
Divisions:Henley Business School > ICMA Centre
ID Code:84083
Publisher:Elsevier

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