Journal of Economic Behavior & Organization 76 (2010) 267–282

Contents lists available at ScienceDirect

Journal of Economic Behavior & Organization

journal homepage: www.elsevier.com/locate/jebo

Investor mood and financial markets

Hui-Chu Shu ∗
Department of International Business, China University of Science and Technology, No.245, Sec. 3, Academia Rd., Nangang Dist., Taipei City 115, Taiwan, ROC

a r t i c l e i n f o a b s t r a c t

Article history: Numerous studies in recent decades have linked investor mood and financial market behav-
Received 4 December 2009 ior, but most works have been empirical investigations. This paper bridges the gap between
Received in revised form 3 June 2010
empirical findings and financial theory. By slightly modifying the Lucas (Lucas, R.E., 1978.
Accepted 10 June 2010
Asset prices in an exchange economy. Econometrica 46, 1429–1445.) model, this study
Available online 25 June 2010
shows how investor mood variations affect equilibrium asset prices and expected returns.
Analysis results indicate that both equity and bill prices correlate positively with investor
JEL classification:
mood, with higher asset prices associated with better mood. Conversely, expected asset
G11
G12 returns correlate negatively with investor mood. Further, the mood effect on asset prices
D81 increases when investors are in a good mood, and mood variations exhibit a greater influ-
E44 ence on equity markets than on bill markets. Results of this study suggest that investor mood
is a vital factor in equilibrium asset prices and returns, and integrating investor mood into
Keywords: asset-pricing models helps to interpret the growing body of seemingly anomalous evidence
Investor mood
regarding investor behavior.
Asset pricing
Behavioral finance
© 2010 Elsevier B.V. All rights reserved.
Time preference
Risk attitude

1. Introduction

This study attempts to link asset-pricing theory, empirical evidence, and psychological research to enhance knowledge
of the role of investor mood in financial markets. In conventional economic analysis, the significance of mood has long been
neglected, whether because its influence is perceived as transient and unimportant, or because investors are assumed to
be entirely rational. However, the traditional perspective is now under challenge. Ample evidence suggests that mood does
significantly influence decision-making, especially when the decision involves risk and uncertainty.
The extent to which investor psychology influences economic behavior has been broadly studied in recent decades
(see, e.g. the reviews of Hirshleifer, 2001; Daniel et al., 2002; Nofsinger, 2005; and Lucey and Dowling, 2005). Researchers
suggest that mood markedly affects judgment and decision-making, subsequently altering investor behavior. The mood or
psychological state of investors when making decisions can affect their preferences, risk assessments and rational cogitations
and, ultimately, their investment decisions. Therefore, financial decisions should vary with investor mood.
A strand of empirical research in behavioral finance has accumulated persuasive evidence that stock returns are related
to mood proxy variables, such as weather (e.g. Saunders, 1993; Hirshleifer and Shumway, 2003; Krivelyova and Robotti,
2003; Cao and Wei, 2005; Chang et al., 2006; Keef and Roush, 2007; and Shu and Hung, 2009), biorhythms (e.g. Kamstra et
al., 2000; Kamstra et al., 2003; and Yuan et al., 2006), and beliefs (Dowling and Lucey, 2005). These studies argue that certain
variables affect the mood or emotions of investors and thus influence their decisions. Consequently, asset prices and returns
fluctuate with investor mood.

∗ Tel.: +886 2 2936 9164.

E-mail addresses: d91724015@ntu.edu.tw, shu0123456@yahoo.com.tw.

0167-2681/$ – see front matter © 2010 Elsevier B.V. All rights reserved.
doi:10.1016/j.jebo.2010.06.004
268 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

However, compared to the extensive empirical evidence that mood affects financial markets, its effects on equilibrium
asset prices are relatively unsubstantiated. Although some studies in the past decade have modeled investor psychology, most
have focused on psychological bias (e.g. narrow-framing, overconfidence, representativeness heuristic, over- and under-
reaction, ambiguity aversion and familiarity) or on concern about future feelings (e.g. loss- and disappointment-aversion)
rather than on mood variations. Thus, the influence of shifting investor mood on equilibrium asset prices and returns remains
an open challenge.
Thus, this study attempts to fill the above gap in the literature by investigating the influence of investor mood variations on
financial markets using a simple general equilibrium asset-pricing model. By slightly modifying the Lucas (1978) model, this
study demonstrates how slight mood variations can induce financial market fluctuation. Drawing on psychological literature,
time preference and risk attitude are employed as mood factors. This analytical work shows that the model satisfactorily
explains many financial market phenomena.
This study offers a general equilibrium perspective of the claims that better investor mood is associated with higher asset
prices, that mood variations have a greater effect on asset prices when most investors are in a good mood than when they
are in a bad mood, and that mood influences equity markets more than it affects bill markets since investing in the former
entails increased complexity and uncertainty. Above analytical results are consistent with psychological concepts.
This preliminary study attempts to link traditional asset-pricing models, behavior finance, and psychology. Traditional
asset-pricing models have been argued to fail to account for historically observed asset returns as they ignore investor
psychology aspects, and empirical research in behavior finance have documented the impact of investor mood on financial
markets (see the review of Hirshleifer, 2001; Lucey and Dowling, 2005) while lacking explicit economic theoretical expla-
nation. If only traditional models, or behavioral finance, or psychology could provide a single but fragmentary knowledge
for the complexity of investor behavior. Standing along, each has its limitations. Merged together, their knowledge and
insights become more powerful, meaningful, and applicable to the reality. This work links the psychology literature with
mood factors and shows that introducing mood factors into a traditional asset-pricing model adequately explains several
empirical findings in behavior finance research and also improves understanding of mood in financial markets.
Briefly, this study contributes to the literature by identifying the economic effects of investor mood variations on equi-
librium asset prices and returns. In addition to connecting psychology research and asset-pricing theory, this study also
bridges the gap between theory and practical evidence. By associating theory, empirical findings, and psychology, this study
improves understanding of the role of mood in financial markets. Above all, this study contributes to the growing literature
on mood and investor behavior (e.g. Loewenstein, 2000; Mehra and Sah, 2002; Lo and Repin, 2002; Falato, 2009).
The rest of this paper is organized as follows. Section 2 reviews pertinent psychological literature on how mood affects
judgment, decision-making, time preferences and risk attitude. Section 3 then summarizes the empirical findings that this
study attempts to explain. Next, Section 4 introduces the proposed model and derives the closed-form expressions for the
prices and expected returns of equities and bills. Section 5 analyzes the influence of mood variations on asset prices and
returns. Conclusions are finally drawn in Section 6, along with recommendations for future research.

2. Psychology literature review

2.1. Effect of mood on judgment and decision-making

Traditional economic theory assumes that people are always rational. However, the traditional perspective is arguably
unrealistic as it overlooks the influence of mood. Psychological research has amply documented the effects of mood on
judgment and decision-making and suggests that mood is an influential factor in preferences (Loewenstein, 1996; Mehra
and Sah, 2002), cognitive processes (Isen, 2001), and in the integration of information (Estrada et al., 1997). Mood is arguably
an important focusing mechanism in economic decision-making (Etzioni, 1988), and good mood is associated with fast and
efficient decision-making (Forgas, 1998).
Mood may cause decision-making to deviate from the optimum or from rationality. Loewenstein et al. (2001) developed
a “risk-as-feelings” model that incorporated the influence of mood on decision-making. The model assumed that emotional
reactions can influence, and even override, rational cogitations on decisions involving risk and uncertainty, and anticipated
emotions influence the cognitive evaluation process and ultimately the decisions.
Of the numerous psychological theories of how mood affects perception, the one quoted most frequently by financial
economists is misattribution: people tend to attribute their feelings to the wrong sources, which causes incorrect judgments
(Frijda, 1988; Schwarz and Clore, 1983). For example, people in a good mood that is induced by good weather may uncon-
sciously attribute this feeling to favorable life prospects. Schwarz and Clore (1983) found that people tend to rate their life
satisfactions much higher on sunny days than on cloudy or rainy days, even though their well being does not change on a
daily basis. Similarly, Wright and Bower (1992) showed that happy people are more optimistic and assign higher probabili-
ties to positive events. Forgas and Ciarrochi (2001) asserted that people in a good mood assign a higher value to both actual
and potential wealth. Accordingly, Nofsinger (2005) suggested that people in a good mood are more willing to invest in risky
assets than those in a bad mood, and vice versa.
Notably, the effect of mood on judgment and decision-making depends on the information environment and the com-
plexity of the decision. According to the affect heuristic theory, using affective impression to make decisions is much easier
than judging probability when the decisions are complex or full of uncertainty (MacGregor et al., 2000). Finucane et al. (2000)
 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282 269

found that, people with abundant information tend to rely on simplified rules or heuristics that either use partial information
or deal with information in incomplete ways. The higher complexity of judgment usually impels people to weigh affective
cues more heavily than technical indicators. Forgas (1995) argued that decision characteristics like risk and uncertainty
determine the importance of feelings. The higher the complexity and uncertainty of a situation, the greater the influence
of emotions on decision making is. Similarly, Conlisk (1996) claimed that cognitive constraints and excessive information
usually hinder people from making fully rational decisions under complex states. Hence, people are prone to make satisfying
rather than optimal decisions. Kaufman (1999) and Hanoch (2002) suggested that people rely on their emotions to make
satisfying decisions under bounded rationality.
Mood effects depend not only on decision characteristics, but also on mood status. People in a good mood are reportedly
easily influenced by emotional factors. According to the “mood-as-information” theory (Schwarz, 1990), people tend to
make decisions that are congruent with their moods. Specifically, people in a good mood are prone to react to irrelevant
information, whereas people in a bad mood tend to process information more carefully and to react more strongly to
truly relevant news. Similarly, Schwarz and Bless (1991) claimed that good mood is usually associated with optimistic
judgments and tend to cause heuristic styles of information processing. Thus, good mood is associated with greater mood
effects.
Thus, psychological research suggests that mood significantly affects judgment and decision-making, even though people
are usually unconscious of it. Especially, mood effect on judgment and decision-making are related to the uncertainty
and complexity of decisions, with higher uncertainty and complexity associated with a greater mood effect. Interestingly,
compared to people in a bad mood, people in a good mood are more optimistic about their the future prospects and rely
more on heuristic styles of information processing; they are more willing to invest in risky assets and are easily affected by
mood factors.

2.2. Influence of mood on time preference and risk attitude

Time preference measures the marginal rate of substitution between current and future consumption and hence plays
an important role in theories of investment and asset pricing. Since Samuelson’s (1937) discounted utility model, time
preference has conventionally taken as given or as constant.
However, psychological studies suggest that time preference varies with circumstance. Postponing consumption involves
self-control and is therefore related to mood and feelings. Loewenstein and Prelec (1992) demonstrated that time preference
differs greatly in different decision domains. Becker and Mulligan (1997) developed a model to show that time preference
is determined endogenously. In their framework, time preference is not a fixed parameter and can be affected by numerous
variables such as wealth, mortality, and uncertainty. As some of these variables are random by nature, individual time
preferences may fluctuate over time.
Loewenstein (2000) further argued that visceral factors such as mood play a critical role in intertemporal choice. As
surveys of economic behavior generally report very low correlations between the different intertemporal trade-offs made
by the same individual, Loewenstein suggested that including the effect of visceral factors may help to explain inconsistencies
in concern for the future over time. In particular, understanding the mood people experience at the time of consuming is
critical for understanding and predicting the intertemporal trade-offs that they make.
Notably, preferences vary with time, but people tend to inaccurately predict the future sequence of their preferences
and systematically overstate the degree to which their future preferences resemble present preferences (Loewenstein et al.,
2003). Given intertemporal choices, people tend to overestimate the duration and intensity of their present tastes. Thus,
although time preference varies with time, people tend to discount future cash flow by the subjective discount rate of the
decision moment.
Additionally, psychological research also suggests that mood can affect risk assessments and risk attitudes. Johnson and
Tversky (1983) found that misattribution of mood can influence perceived risk. That is, people may not realize that their
risky decisions are influenced by mood.
Furthermore, Mann (1992) and Nygren et al. (1996) argued that mood affects individual perception and judgment of
risk, while Isen and Geva (1987) claimed that mood alters risk preference. Loewenstein (2000) suggested that cognitive
evaluations of risks often diverge from emotional reactions to those risks. Therefore, considering the effect of immediate
emotions on risky behavior can elucidate many otherwise anomalous risk-taking phenomena. Meanwhile, economic studies
suggest that people are more risk averse after an initial loss (Thaler and Johnson, 1990) or when they are depressed (Kamstra
et al., 2003).
Specifically, risk attitude depends on mood status. People in a good mood reportedly underestimate risk and overestimate
benefit (Finucane et al., 2000), and are more willing than people in a bad mood to invest in risky assets (Nofsinger, 2005). Au
et al. (2003) found that foreign exchange traders in a pleasant mood environment tend to be overconfident, take superfluous
risks, make worse decisions, and perform poorly. Conversely, traders in a bad mood environment are more conservative and
make better decisions.
Briefly, previous studies suggest that time preference fluctuates over time. However, when faced with intertemporal
choices, people often assume present preference do not change. Further, time preference and risk attitude are affected by
mood and are thus good mood proxy variables. Finally, as people in a good mood tend to take more risks or to undervalue
risk, they are assumed to be less risk averse than people in a bad mood, and vice versa.
270 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

3. Evidence

As behavioral finance emerges in mainstream financial research, a growing number of financial studies have attempted
to link investor mood with stock prices. Such studies have investigated the possible relationship between stock prices and
mood proxy variables such as weather and biorhythms. Drawing on psychological evidence, these empirical studies argue
that certain variables can cause broadly uniform fluctuations in the mood of large groups of people and might therefore
affect their financial decisions and, ultimately, stock prices.
Weather, with the documented influence on moods (e.g. Goldstein, 1972; Cunningham, 1979; Sanders and Brizzolara,
1982; Schwarz and Clore, 1983; Howarth and Hoffman, 1984; Parrott and Sabini, 1990; Watson, 2000) and behavior (Baron
and Ransberger, 1978; Allen and Fisher, 1978; Cunningham, 1979; Schneider et al., 1980; Rotton and Cohn, 2000; Anderson,
2001; Pilcher et al., 2002), has attracted much interest. It is well recognized that pleasant weather causes a good mood and
nasty weather causes a bad mood (e.g. Schwarz and Clore, 1983; Keller et al., 2005). Weather variables known to correlate
with stock prices include sunshine, temperature, wind, and geomagnetic storms. The research in this area indicates that
pleasant weather triggers a good mood and hence induces a mood misattribution that guides investors to price stocks
optimistically, and vice versa.
Saunders (1993) as well as Hirshleifer and Shumway (2003) found that sunshine is highly correlated with stock returns.
They claimed that sunny weather is associated with upbeat and optimistic investor mood, which makes investors more likely
to buy stocks. Substantial psychological evidence supports this argument. Sunshine is a significant weather-based influence
on mood and behavior. As hours of sunshine increase, depression (Eagles, 1994) and skepticism (Howarth and Hoffman,
1984) decrease whereas optimism (Howarth and Hoffman, 1984) and general good mood (Persinger, 1975) increase.
Krivelyova and Robotti (2003) further identified a negative correlation between geomagnetic storms and stock returns.
According to that study, individuals tend to sell stocks on days with geomagnetic storms, which they contended is driven by
investors incorrectly attributing their bad mood to negative economic prospects rather than to adverse weather conditions.
Consequently, high geomagnetic activity is followed by negative stock returns while stock returns increase during periods
of quiet geomagnetic activity. Similarly, temperature (Cao and Wei, 2005; Chang et al., 2006; and Keef and Roush, 2007) and
wind (Keef and Roush, 2007; Shu and Hung, 2009) reportedly have a negative influence on stock prices.
In addition to weather effects, another branch of research indicates that biorhythms (the body’s natural biological cycles)
also correlate with stock returns. As in weather-effect research, this body of literature examines whether a widely fluctuating
mood induced by biorhythms is misattributed by investors and allowed to inform the stock investment decision. For instance,
Kamstra et al. (2000) found that stock returns on Mondays following daylight savings time changes are significantly lower
than those on other Mondays. Their results suggested that the anxiety induced by interrupted sleep patterns may temporarily
increase risk aversion and trigger stock sales, thereby causing falling prices.
A further study by Kamstra et al. (2003) found that the seasonal affective disorder (SAD) explains seasonal variations
in stock returns. Kamstra et al. asserted that depression induced by longer winter nights makes investors more risk-averse
and unwilling to hold stocks. Thus, autumn to winter is associated with increasingly negative returns as the length of night
increases while winter to spring is associated with increasingly positive returns as the length of night decreases. Similarly,
Yuan et al. (2006) found that stock returns are significantly lower on the days around a full moon than on the days around
a new moon, and argued that the depressed mood associated with a full moon makes investors value stocks less and thus
induces lower returns during full moon periods. Additionally, Ariel (1990) claimed that high pre-holiday returns can be
interpreted by good investor mood due to the expectation of having a holiday.
Notably, the strength of the mood effect on stock markets may vary with investor mood status. Dowling and Lucey (2005)
investigated the relationship between eight mood proxy variables and daily stock returns and found that the relationship
between mood proxy variables and equity returns is more pronounced in times of positive recent market performance. They
suggested that people in a good mood are more likely to allow irrelevant mood factors to influence their decisions.
The strength of mood effects also depends on the complexity of the decision. For instance, small stocks and closed-end
funds exhibit larger prices anomalies, probably due to the greater reliance on emotional decision-making of individual
investors, who have a large influence on the pricing of these assets (Lee et al., 1991; Chopra et al., 1993). As investment
decisions are more complex and risky for individual investors than for professional investors, and since greater uncertainty
is linked with greater reliance on mood and feelings in the decision-making process (Forgas, 1995), the assets mainly owned
by individual investors are more likely to be influenced by investor mood than those mainly owned by institutional investors.
Thus, empirical studies indicate that investor mood significantly influences stock prices and that better mood is associated
with higher prices, and vice versa. Additionally, people in a good mood are more easily affected by irrelevant mood factors,
and the effect of mood increases when the decision is complex and uncertain. However, although these empirical findings
coincide with the psychological argument, a economic model is still needed to explain the phenomena. Theoretical support
is needed in order for research into the mood effect on investor behavior to progress and to become paradigmatic, which is
the motivation for this study.

4. Proposed model

This analysis is based on a simple general equilibrium model. The simplicity of the model not only facilitates exposition
and derives explicit conclusions, it also suits the questions posed. This analysis employs a variation of the Lucas (1978) pure
 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282 271

exchange model, while assumes that the growth rate of consumption, rather than consumption level, follows a Markov
process. Consider a closed economy with a representative agent. In period t, the agent wishes to maximize the expected
utility
⎡ ⎤
∞
Ut = Et ⎣ ˇj u(ct+j )]⎦ (1)
j=0

where ct is the consumption in period t, u( ) is the period utility function, Et [ ] is an expectations operator conditional upon the
information available at time t, and ˇ ∈ (0, 1) is the subjective discount factor representing time preference. The subjective
discount factor is used to discount the individual flow of future expected utilities and can thus be considered the marginal
rate of substitution between two successive flows of expected utilities. Restated, ˇ represents the patience of the individual
for future consumption, with higher ˇ meaning more patient.
To ensure a stationary equilibrium return process, the period utility function is specified as the constant relative risk
aversion (CRRA) class:

ct1−˛
u(ct ) = , 0<˛<∞ (2)
1−˛
where ˛ represents the parameter of relative risk aversion. When ˛ equals one, the utility function is defined as logarithmic.
Thus, this utility function is the standard time-separable iso-elastic utility function, which satisfies the following strictly
increasing and concave condition: ∂u/∂c > 0;∂2 u /∂2 c < 0.
At an optimum, the equilibrium equity return Rt+1 must satisfy the Euler equation:
 u (c ) 
t+1
Et ˇ Rt+1 = 1 (3)
u (ct )
where Rt+1 = (pt+1 + dt+1 )/pt , pt is the ex-dividend share price in period t, dt is the dividend payout in that period, and u ( )
denotes the derivative of u with respect to its argument. This definition ensures that the economy is arbitrage-free and the
law of one price holds.
For risk-free bills, the Euler equation becomes
 u (c ) 
t+1 B
Et ˇ Rt+1 =1 (4)
u (ct )
with
B
Rt+1 = 1/pBt (5)

where pBtis the time t price of a one-period risk-free bill that pays one unit of consumption good in period t + 1. Eqs. (3) and
(4) follow from an extension of Lucas (1978) by Mehra (2003).
Assume that only one productive unit is producing the consumption good, that the good is perishable, and that one equity
share is competitively traded. As only one productive unit is considered, the return on this share equals the market returns.
In equilibrium, all output is consumed in the same period it is produced, no other source of the consumed good is available,
and dividend payout in that period equals output in period t. Hence, ct = dt , and it follows that ct+1 /ct = dt+1 /dt = xt+1 , where
xt+1 represents the consumption (dividend) growth rate which is assumed to be identically and independently distributed.
So that
−˛
u (ct+1 )/u (ct ) = xt+1 (6)

4.1. Closed-form solutions for bill prices and returns

Substituting Eqs. (5) and (6) into Eq. (4) yields

 u (c 
t+1 ) −˛
PtB = ˇEt = ˇEt (xt+1 ) (7)
u (ct )
So that
B 1
Rt+1 = −˛ (8)
ˇEt (xt+1 )

Let the consumption growth rate x follow the geometric Brownian process:
dx
= udt + dW (9)
x
where W is the unit Weiner process. Thus, x follows the lognormal distribution with expected value u − (1/2) 2 and variance
 2 . The time interval is set to be 1 year.
272 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

Then, using the properties of the lognormal distribution, the price and return of the bill can be expressed in a closed-form
manner as follows:
˛ 2 2 2
+ ˛ 2
PtB = ˇe−˛u+ 2 (10)

B 1 ˛u− ˛2
2 2 2
− ˛ 2
Rt+1 = e (11)
ˇ

The derivation of (10) and (11) is listed in Appendix A.

4.2. Closed-form solutions for equity prices and returns

Let wt denote the price-dividend ratio, therefore, wt ≡ pt /dt . Since pt is homogeneous of degree 1 in dt , it follows that
pt = wt dt and pt+1 = wt+1 dt+1 . As Rt+1 = (pt+1 + dt+1 )/pt , which can be rewritten as

(1 + wt+1 )xt+1
Rt+1 = (12)
wt

Thus, substituting (12) into (4) yields:

1−˛
ˇE(xt+1 ) ˇyt+1
wt = = (13)
1−˛
1 − ˇE(xt+1 ) 1 − ˇyt+1

1−˛
where yt+1 ≡ E(xt+1 ).
Substituting the definition of wt , that is, wt ≡ pt /dt into (13) yields the closed-form solution of equity prices:

ˇek
pt = dt (14)
1 − ˇek
2
where k ≡ (1 − ˛) (u − ˛2 )
Algebraic operation yields:

1 ˛u+ ˛ 2 − ˛2  2 −  2
E(Rt+1 ) = e 2 2 2 (15)
ˇ

The derivation of (15) is listed in Appendix A.

5. The economic meaning of variations in mood factors

Since psychological experiments have documented the effects of mood on risk attitude and time preference, this analysis
uses these two variables as mood factors to explore the effect of mood. To elucidate the effects of small mood variations on
equilibrium asset prices and expected returns, both bill and equity prices and expected returns are partially differentiated
to mood factors to examine the effects of mood.

5.1. Effects of varying mood factors on asset prices

This section investigates how slight variations in mood factors affect asset prices. Based on (10) and (14), the following
is derived:

∂PtB ˛ 2 ˛2  2
= e−˛u+ 2 + 2 (16)
∂ˇ

∂PtB 2 ˛ 2 ˛2  2
= −(u − − ˛ 2 )ˇe−˛u+ 2 + 2 (17)
∂˛ 2
˛ 2
∂Pt e(1−˛) (u− 2
)
= dt 2
(18)
∂ˇ (1−˛) (u− ˛2 )
2
(1 − ˇe )

∂Pt 2 ek
= −dt ˇ(u + − ˛ 2 ) 2
(19)
∂˛ 2 (1 − ˇek )
 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282 273

Table 1
Variations in bill prices induced by time preference.

1.01 2 3 4 5 6 7 8 9 10
∂P B
t
∂ˇ
0.983 0.968 0.954 0.942 0.931 0.921 0.912 0.905 0.899 0.893

This table displays the variations in bill prices that are caused by variations in the time preference. The values in this table are obtained by partially
differentiating bill prices to the subjective discount factor as expressed in Eq. (16):

∂PtB 2 /2)+(˛2  2 /2)

= e−˛u+(˛
∂ˇ

Table 2
Variations in equity prices induced by the time preference.

ˇ 1.01 2 3 4 5 6 7 8 9 10

0.1 0.025 0.024 0.024 0.023 0.023 0.023 0.022 0.022 0.022 0.022
0.2 0.031 0.030 0.030 0.029 0.029 0.028 0.028 0.027 0.027 0.027
0.3 0.041 0.040 0.038 0.037 0.037 0.036 0.035 0.035 0.034 0.034
0.4 0.056 0.053 0.052 0.050 0.049 0.047 0.046 0.045 0.044 0.044
0.5 0.080 0.076 0.073 0.070 0.067 0.065 0.063 0.062 0.060 0.059
0.6 0.125 0.117 0.110 0.105 0.100 0.096 0.092 0.089 0.087 0.085
0.7 0.222 0.203 0.186 0.173 0.162 0.153 0.146 0.140 0.135 0.131
0.8 0.499 0.432 0.381 0.341 0.310 0.286 0.266 0.250 0.237 0.227
0.9 1.993 0.475 1.170 0.960 0.813 0.708 0.629 0.570 0.526 0.491
0.92 3.112 2.165 1.622 1.284 1.059 0.903 0.790 0.707 0.645 0.599
0.94 5.524 3.438 2.396 1.805 1.437 1.192 1.022 0.900 0.811 0.745
0.96 12.394 6.278 3.892 2.721 2.058 1.646 1.373 1.185 1.050 0.953
0.98 49.151 14.924 7.395 4.565 3.191 2.419 1.942 1.628 1.413 1.262
0.99 193.26 28.072 11.249 6.282 4.145 3.027 2.368 1.949 1.669 1.476

This table displays the variations in equity prices that are caused by variations in the time preference. The values in this table are obtained by partially
differentiating equity prices to the time preference as expressed in Eq. (18):
˛ 2 )
∂Pt e(1−˛) (u− 2
= dt 2
∂ˇ ˛ 2 )
(1 − ˇe(1−˛) (u− 2 )

Tables 1–4 and the corresponding Figs. 1–4 summarize the results of comparative static analysis. This analysis uses the
parameter values u = 0.018 and  = 0.035 obtained by Mehra and Sah (2002),1 and the dividend is set at 0.02.2
In Tables 1 and 2, the partial derivative of asset prices with respect to ˇ is positive, meaning that both bill and equity
prices increase as the agent becomes more patient. Thus, a higher ˇ is associated with higher asset prices. Fig. 1 shows the
decreasing and nearly linear relationship between ∂PtB /∂ˇ and ˛. Accordingly, increment in bill prices induced by ˇ increases
when the agent is less risk averse.
Meanwhile, the influence of time preference on equity prices is substantial for generally proposed ˇ, namely ˇ > 0.9. For
example, in the case of ˇ = 0.98, when ˛ = 2, the increment in equity prices induced by ˇ is 14.9 times the increment in ˇ, and
the multiplier rises to 28 when ˇ = 0.99, indicating that a slight shift in time preference can significantly change equity prices.
Tables 3 and 4 show that the partial derivative of bill and equity prices with respect to ˛ is negative. As expected, the
prices of both assets fall as the agent becomes more risk averse.
Notably, mood factors exert more influence on equity prices than on bill prices for ˇ > 0.9. For example, when ˛ = 2 and
ˇ = 0.98, the variation in equity prices induced by ˛ is about seventeen times that in bill prices. Similarly, in the same case,
when ˇ changes, the induced increment in equity prices is about fifteen times that in bill prices. These mathematical results
suggest that equity prices are more easily influenced by mood variations than are bill prices.
Finally, all of the figures reveal an interesting phenomenon. The effects of both mood factors are enhanced in situations
of low ˛ and high ˇ, indicating that an agent with high time preference and low risk aversion is easily affected by mood
factors when pricing assets.
Thus, the above analytical results reveal patterns in line with the empirical findings. First, better investor mood is asso-
ciated with higher asset price, since an increased time preference and a decreased risk-aversion coefficient induce higher
prices. Psychological research indicates that people in a good mood tend to underestimate risk (Finucane et al., 2000) or to
take more risk (Au et al., 2003). Thus, a reasonable inference is that investors in a good mood are less risk averse, and vice

1
Mehra and Sah (2002) obtained the parameter values from data on U.S. per capita real consumption of non-durables and services.
2
Changing the dividend rate would induce the partial derivative of asset prices to mood factors to shift the same percentage as the variation in the
dividend rate.
274 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

Table 3
Variations in bill prices induced by the relative risk-aversion coefficient.

ˇ 1.01 2 3 4 5 6 7 8 9 10

0.1 −0.0016 −0.0014 −0.0013 −0.0012 −0.0010 −0.0009 −0.0008 −0.0007 −0.0006 −0.0005
0.2 −0.0032 −0.0029 −0.0026 −0.0024 −0.0021 −0.0018 −0.0016 −0.0014 −0.0011 −0.0009
0.3 −0.0048 −0.0043 −0.0039 −0.0035 −0.0031 −0.0028 −0.0024 −0.0021 −0.0017 −0.0014
0.4 −0.0064 −0.0058 −0.0052 −0.0047 −0.0042 −0.0037 −0.0032 −0.0027 −0.0023 −0.0018
0.5 −0.0079 −0.0072 −0.0065 −0.0059 −0.0052 −0.0046 −0.0040 −0.0034 −0.0029 −0.0023
0.6 −0.0095 −0.0087 −0.0079 −0.0071 −0.0063 −0.0055 −0.0048 −0.0041 −0.0034 −0.0028
0.7 −0.0111 −0.0101 −0.0092 −0.0082 −0.0073 −0.0065 −0.0056 −0.0048 −0.0040 −0.0032
0.8 −0.0127 −0.0116 −0.0105 −0.0094 −0.0084 −0.0074 −0.0064 −0.0055 −0.0046 −0.0037
0.9 −0.0143 −0.0130 −0.0118 −0.0106 −0.0094 −0.0083 −0.0072 −0.0062 −0.0051 −0.0041
0.92 −0.0146 −0.0133 −0.0120 −0.0108 −0.0096 −0.0085 −0.0074 −0.0063 −0.0053 −0.0042
0.94 −0.0149 −0.0136 −0.0123 −0.0111 −0.0099 −0.0087 −0.0076 −0.0065 −0.0054 −0.0043
0.96 −0.0152 −0.0139 −0.0126 −0.0113 −0.0101 −0.0089 −0.0077 −0.0066 −0.0055 −0.0044
0.98 −0.0156 −0.0142 −0.0128 −0.0115 −0.0103 −0.0091 −0.0079 −0.0067 −0.0056 −0.0045

This table displays the variations in bill prices that are caused by variations in the relative risk-aversion coefficient. The values in this table are obtained by
partially differentiating bill prices to the relative risk-aversion coefficient as expressed in Eq. (17):

∂PtB 2 ˛ 2 ˛2  2
= −(u − − ˛ 2 )ˇe−˛u+ 2 + 2
∂˛ 2

Table 4
Variations in equity prices induced by the relative risk-aversion coefficient.

ˇ 1.01 2 3 4 5 6 7 8 9 10

0.1 −4.3E−05 −3.9E−05 −3.5E−05 −3.2E−05 −2.9E−05 −2.6E−05 −2.2E−05 −1.9E−05 −1.7E−05 −1.4E−05
0.2 −0.00011 −0.00010 −0.00009 −0.00008 −0.00007 −0.00006 −0.00006 −0.00005 −0.00004 −0.00003
0.3 −0.0002 −0.0002 −0.0002 −0.0002 −0.0001 −0.0001 −0.0001 −0.0001 −0.0001 −0.0001
0.4 −0.0004 −0.0003 −0.0003 −0.0003 −0.0002 −0.0002 −0.0002 −0.0002 −0.0001 −0.0001
0.5 −0.0007 −0.0006 −0.0005 −0.0005 −0.0004 −0.0004 −0.0003 −0.0003 −0.0002 −0.0002
0.6 −0.0013 −0.0011 −0.0010 −0.0009 −0.0007 −0.0006 −0.0006 −0.0005 −0.0004 −0.0003
0.7 −0.0027 −0.0023 −0.0019 −0.0017 −0.0014 −0.0012 −0.0010 −0.0009 −0.0007 −0.0006
0.8 −0.0069 −0.0056 −0.0046 −0.0037 −0.0031 −0.0026 −0.0021 −0.0018 −0.0014 −0.0012
0.9 −0.0312 −0.0062 −0.0157 −0.0118 −0.0091 −0.0072 −0.0057 −0.0045 −0.0036 −0.0028
0.92 −0.0497 −0.0322 −0.0223 −0.0162 −0.0122 −0.0094 −0.0073 −0.0057 −0.0045 −0.0035
0.94 −0.0902 −0.0522 −0.0336 −0.0233 −0.0169 −0.0126 −0.0096 −0.0075 −0.0058 −0.0045
0.96 −0.2067 −0.0974 −0.0558 −0.0358 −0.0247 −0.0178 −0.0132 −0.0100 −0.0077 −0.0058
0.98 −0.8369 −0.2364 −0.1083 −0.0613 −0.0390 −0.0267 −0.0191 −0.0141 −0.0105 −0.0079

This table displays the variations in equity prices that are caused by variations in the relative risk-aversion coefficient. The values in this table are obtained
by partially differentiating equity prices to the relative risk-aversion coefficient as expressed in Eq. (19):

∂Pt 2 ek
= −dt ˇ(u + − ˛ 2 )
∂˛ 2 (1 − ˇek )
2

Fig. 1. Variations in bill prices induced by the time preference.

 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282 275

Fig. 2. Variations in equity prices induced by the time preference.

Fig. 3. Variations in bill prices induced by the relative risk-aversion coefficient.

Fig. 4. Variations in equity prices induced by the relative risk-aversion coefficient.

276 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

Table 5
Variations in bill returns induced by the time preference.

ˇ 1.01 2 3 4 5 6 7 8 9 10

0.1 −101.708 −103.285 −104.776 −106.157 −107.425 −108.575 −109.604 −110.506 −111.280 −111.921
0.2 −25.427 −25.821 −26.194 −26.539 −26.856 −27.144 −27.401 −27.627 −27.820 −27.980
0.3 −11.301 −11.476 −11.642 −11.795 −11.936 −12.064 −12.178 −12.278 −12.364 −12.436
0.4 −6.357 −6.455 −6.548 −6.635 −6.714 −6.786 −6.850 −6.907 −6.955 −6.995
0.5 −4.068 −4.131 −4.191 −4.246 −4.297 −4.343 −4.384 −4.420 −4.451 −4.477
0.6 −2.825 −2.869 −2.910 −2.949 −2.984 −3.016 −3.045 −3.070 −3.091 −3.109
0.7 −2.076 −2.108 −2.138 −2.166 −2.192 −2.216 −2.237 −2.255 −2.271 −2.284
0.8 −1.589 −1.614 −1.637 −1.659 −1.679 −1.696 −1.713 −1.727 −1.739 −1.749
0.9 −1.256 −1.275 −1.294 −1.311 −1.326 −1.340 −1.353 −1.364 −1.374 −1.382
0.92 −1.202 −1.220 −1.238 −1.254 −1.269 −1.283 −1.295 −1.306 −1.315 −1.322
0.94 −1.151 −1.169 −1.186 −1.201 −1.216 −1.229 −1.240 −1.251 −1.259 −1.267
0.96 −1.104 −1.121 −1.137 −1.152 −1.166 −1.178 −1.189 −1.199 −1.207 −1.214
0.98 −1.059 −1.075 −1.091 −1.105 −1.119 −1.131 −1.141 −1.151 −1.159 −1.165

This table displays the variations in bill returns that are caused by variations in the time preference. The values in this table are obtained by partially
differentiating bill returns to the time preference as expressed in Eq. (15):
B
∂Rt+1 1 ˛u− ˛ 2 − ˛2  2
=− e 2 2
∂ˇ ˇ2

versa. Further, since investors in a good mood are usually more optimistic about future prospects (Wright and Bower, 1992;
Schwarz and Bless, 1991) and are more willing to invest (Nofsinger, 2005) than are investors in bad moods, a reasonable
inference is that good mood is associated with high time preference. Thus, this result provides theoretical support for the
argument of empirical studies that improved investor mood increases asset prices (e.g. Saunders, 1993; Hirshleifer and
Shumway, 2003; Krivelyova and Robotti, 2003; Kamstra et al., 2003; Yuan et al., 2006; Shu and Hung, 2009).
Second, mood factors, especially time preference, significantly influence asset prices. A slight change in time preference
can cause great variation in equity prices. The variation in risk attitude has a smaller but still unignorable influence. Thus, if
certain variables alter the time preference of investors even slightly, equity prices may shift significantly.
Third, mood variations have a greater effect on asset prices when investor mood is good as the variation in asset prices
caused by changing mood increases when the agent has lower risk aversion and higher time preference. As investors in
a good mood are less risk averse and more patient, these results coincide with psychological argument that people in a
good mood are more likely to allow mood-related factors to influence their decision-making process, and also support the
empirical findings of Dowling and Lucey (2005).
Finally, mood variations have a stronger association with equity prices than with bill prices, which suggests that equity
investments are more likely to be influenced by mood fluctuations than are bill investments. The psychological literature
suggests that mood plays a more important role in decision-making when uncertainty and complexity is greater (Finucane
et al., 2000; Kaufman, 1999; and Hanoch, 2002). Compared to bill investing, equity investing involves much more risk and
uncertainty and requires more information. Therefore, mood factors should exert a greater effect on equity investment

Table 6
Variations in equity returns induced by the time preference.

ˇ 1.01 2 3 4 5 6 7 8 9 10

0.1 −101.772 −103.475 −105.097 −106.613 −108.019 −109.309 −110.480 −111.526 −112.444 −113.231
0.2 −25.443 −25.869 −26.274 −26.653 −27.005 −27.327 −27.620 −27.881 −28.111 −28.308
0.3 −11.308 −11.497 −11.677 −11.846 −12.002 −12.145 −12.276 −12.392 −12.494 −12.581
0.4 −6.361 −6.467 −6.569 −6.663 −6.751 −6.832 −6.905 −6.970 −7.028 −7.077
0.5 −4.071 −4.139 −4.204 −4.265 −4.321 −4.372 −4.419 −4.461 −4.498 −4.529
0.6 −2.827 −2.874 −2.919 −2.961 −3.001 −3.036 −3.069 −3.098 −3.123 −3.145
0.7 −2.077 −2.112 −2.145 −2.176 −2.204 −2.231 −2.255 −2.276 −2.295 −2.311
0.8 −1.590 −1.617 −1.642 −1.666 −1.688 −1.708 −1.726 −1.743 −1.757 −1.769
0.9 −1.256 −1.277 −1.297 −1.316 −1.334 −1.349 −1.364 −1.377 −1.388 −1.398
0.92 −1.202 −1.223 −1.242 −1.260 −1.276 −1.291 −1.305 −1.318 −1.329 −1.338
0.94 −1.152 −1.171 −1.189 −1.207 −1.222 −1.237 −1.250 −1.262 −1.273 −1.281
0.96 −1.104 −1.123 −1.140 −1.157 −1.172 −1.186 −1.199 −1.210 −1.220 −1.229
0.98 −1.060 −1.077 −1.094 −1.110 −1.125 −1.138 −1.150 −1.161 −1.171 −1.179

This table displays the variations in equity returns that are caused by variations in the time preference. The values in this table are obtained by partially
differentiating equity returns to the time preference as expressed in Eq. (22):

∂E(Rt+1 ) 1 ˛ 2 ˛2  2 2
= − 2 e˛u+ 2 − 2 − 2
∂ˇ ˇ
 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282 277

Table 7
Variations in bill returns induced by the relative risk-aversion coefficient.

ˇ 1.01 2 3 4 5 6 7 8 9 10

0.1 0.1643 0.1543 0.1437 0.1326 0.1210 0.1090 0.0966 0.0838 0.0708 0.0575
0.2 0.0821 0.0771 0.0718 0.0663 0.0605 0.0545 0.0483 0.0419 0.0354 0.0288
0.3 0.0548 0.0514 0.0479 0.0442 0.0403 0.0363 0.0322 0.0279 0.0236 0.0192
0.4 0.0411 0.0386 0.0359 0.0331 0.0302 0.0272 0.0241 0.0210 0.0177 0.0144
0.5 0.0329 0.0309 0.0287 0.0265 0.0242 0.0218 0.0193 0.0168 0.0142 0.0115
0.6 0.0274 0.0257 0.0239 0.0221 0.0202 0.0182 0.0161 0.0140 0.0118 0.0096
0.7 0.0235 0.0220 0.0205 0.0189 0.0173 0.0156 0.0138 0.0120 0.0101 0.0082
0.8 0.0205 0.0193 0.0180 0.0166 0.0151 0.0136 0.0121 0.0105 0.0089 0.0072
0.9 0.0183 0.0171 0.0160 0.0147 0.0134 0.0121 0.0107 0.0093 0.0079 0.0064
0.92 0.0179 0.0168 0.0156 0.0144 0.0132 0.0118 0.0105 0.0091 0.0077 0.0063
0.94 0.0175 0.0164 0.0153 0.0141 0.0129 0.0116 0.0103 0.0089 0.0075 0.0061
0.96 0.0171 0.0161 0.0150 0.0138 0.0126 0.0114 0.0101 0.0087 0.0074 0.0060
0.98 0.0168 0.0157 0.0147 0.0135 0.0123 0.0111 0.0099 0.0086 0.0072 0.0059

This table displays the variations in bill returns that are caused by variations in the relative risk-aversion coefficient. The values in this table are obtained
by partially differentiating bill returns to the relative risk-aversion coefficient as expressed in Eq. (21):
B
∂Rt+1 1 2 ˛ 2 ˛2  2
= (u − − ˛ 2 )e˛u− 2 − 2
∂˛ ˇ 2

according to the psychological argument. The above finding suggests that, when investor mood changes, investor mood
induces greater variations in the equity market than in the bill market.

5.2. Effects of varying mood factors on asset returns

Varying mood factors that affect equity and bill prices may also impact the expected returns of both assets. The magnitude
and direction of this influence is an interesting inquiry, as is discussed below.
Analogously, partially differentiating the asset returns to mood factors yields the following:
B
∂Rt+1 1 ˛u− ˛ 2 − ˛2  2
=− e 2 2 (20)
∂ˇ ˇ2
B
∂Rt+1 1 2 ˛ 2 ˛2  2
= (u − − ˛ 2 )e˛u− 2 − 2 (21)
∂˛ ˇ 2

∂E(Rt+1 ) 1 ˛ 2 ˛2  2 2
= − 2 e˛u+ 2 − 2 − 2 (22)
∂ˇ ˇ

Table 8
Variations in equity returns induced by the relative risk-aversion coefficient.

ˇ 1.01 2 3 4 5 6 7 8 9 10

0.1 0.1768 0.1672 0.1570 0.1462 0.1349 0.1231 0.1109 0.0983 0.0853 0.0720
0.2 0.0884 0.0836 0.0785 0.0731 0.0674 0.0616 0.0554 0.0491 0.0427 0.0360
0.3 0.0589 0.0557 0.0523 0.0487 0.0450 0.0410 0.0370 0.0328 0.0284 0.0240
0.4 0.0442 0.0418 0.0392 0.0365 0.0337 0.0308 0.0277 0.0246 0.0213 0.0180
0.5 0.0354 0.0334 0.0314 0.0292 0.0270 0.0246 0.0222 0.0197 0.0171 0.0144
0.6 0.0295 0.0279 0.0262 0.0244 0.0225 0.0205 0.0185 0.0164 0.0142 0.0120
0.7 0.0253 0.0239 0.0224 0.0209 0.0193 0.0176 0.0158 0.0140 0.0122 0.0103
0.8 0.0221 0.0209 0.0196 0.0183 0.0169 0.0154 0.0139 0.0123 0.0107 0.0090
0.9 0.0196 0.0186 0.0174 0.0162 0.0150 0.0137 0.0123 0.0109 0.0095 0.0080
0.92 0.0192 0.0182 0.0171 0.0159 0.0147 0.0134 0.0121 0.0107 0.0093 0.0078
0.94 0.0188 0.0178 0.0167 0.0156 0.0144 0.0131 0.0118 0.0105 0.0091 0.0077
0.96 0.0184 0.0174 0.0164 0.0152 0.0141 0.0128 0.0116 0.0102 0.0089 0.0075
0.98 0.0180 0.0171 0.0160 0.0149 0.0138 0.0126 0.0113 0.0100 0.0087 0.0074

This table displays the variations in equity returns that are caused by variations in the relative risk-aversion coefficient. The values in this table are obtained
by partially differentiating equity returns to the relative risk-aversion coefficient as expressed in Eq. (23):

∂E(Rt+1 ) 1 2 ˛ 2 ˛2  2 2
= (u + − ˛ 2 )e˛u+ 2 − 2 − 2
∂˛ ˇ 2
278 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

Fig. 5. Variations in bill returns induced by the time preference.

∂E(Rt+1 ) 1 2 ˛ 2 ˛2  2 2
= (u + − ˛ 2 )e˛u+ 2 − 2 − 2 (23)
∂˛ ˇ 2

Tables 5–8 and Figs. 5–8 present the comparative static results. Tables 5 and 6 show that, the partial derivatives of expected
asset returns with respect to ˇ are negative, which indicate a negative relationship between patience and expected returns.
Thus, a higher ˇ induces a lower expected return. Intuitively, the more patient the agent is, the more willing the agent
would be to sacrifice current consumption to buy assets with lower expected returns. Additionally, as noted in Section 5.1,
asset prices in period t rise as ˇ increases. Because asset prices follow a mean-reverting process, this increased period price
reduces the expected returns of the next period. Hence, these results are consistent with those in Section 5.1.
Notably, the negative influence of ˇ on expected asset returns exceeds one in all cases of ˇ considered in Tables 5 and 6,
which implies that the decrement in asset returns induced by ˇ exceeds the increment in ˇ. Thus, a slight variation in time
preference induces a significant variation in expected returns.
Tables 7 and 8 reveal that ˛ is positively related to the expected returns for both assets. Hence, a higher risk-aversion
coefficient is associated with a higher expected return. The explanation for this result is that a high expected return induces
a risk averse agent to sacrifice consumption during this period to buy assets. Because increased ˛ reduces asset prices in
time t, expected returns for the next period also increase.
In comparison, the influence of ˇ on expected returns is significantly larger than that of ˛. For example, when ˛ = 2 and
ˇ = 0.98, the variation in expected equity returns induced by ˇ is 1.077 times that of ˇ. However, in the same case, the

Fig. 6. Variations in equity returns induced by the time preference.

 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282 279

Fig. 7. Variations in bill returns induced by the relative risk-aversion coefficient.

Fig. 8. Variations in equity returns induced by the relative risk-aversion coefficient.

variation in ˛ induces just 0.017 times the variation in returns. Both mood factors also exert a greater influence on expected
equity returns than on bill returns, which reflects the greater susceptibility of equity returns to fluctuating investor mood.
In sum, the above analytical results indicate some notable patterns. First, investor mood is inversely related to expected
return as increased risk aversion and decreased time preference raise expected asset returns. This finding is economically
intuitive and is consistent with the psychology literature. As psychological studies demonstrate that individuals in a bad
mood are pessimistic and unwilling to invest, high expected returns are required to attract them to invest.
Furthermore, time preference substantially influences expected returns. A change in time preference as small as 0.1 can
induce a 10 percent or larger variation in expected equity returns. Meanwhile, expected returns of both assets are much more
sensitive to varying time preference than to varying risk attitude, and, compared to bill returns, expected equity returns are
more susceptible to mood factors.

6. Conclusion

Wisdom is cultivated by studying the past and by intelligently applying the lessons learned to the present. Importantly,
integrating knowledge from other domains into financial and economic research can help to understand otherwise puzzling
aspects of financial markets. This study adopts a conventional asset-pricing model to show that mild investor mood variations
have rich implications for financial markets. Mood states, a well recognized factor in human perception and behavior, has
an impact on risk attitude and time preference and significantly affects the equilibrium of asset prices and returns. Thus,
understanding mood factors can help to resolve some of the most prominent documented market anomalies.
280 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

To gain further insight into investor behavior, financial economists have growingly accepted psychological explanations.
However, embedding investor mood in theoretical analyses is still at the early stage of research. This analysis provides a
general equilibrium perspective over a broad set of important empirical findings regarding how investor mood fluctuations
affect financial markets. Although the causal association between market anomalies and investor mood is well documented
in the behavioral finance literature, most reported data are empirical. This study fills the gap between practical findings and
asset-pricing theory.
Specifically, this study offers a novel explanation for financial market volatility. The cause of over-volatility in equity
markets has attracted much academic interest, but is still unsolved. This study suggests that considering varying investor
mood can help to explain violent fluctuations in equity markets. This study also suggests that varying time preference sub-
stantially affects equity markets. Increased time preferences significantly increase equity prices and reduce expected equity
returns. Thus, if investor time preferences are even slightly altered by certain factors, the equity markets may accordingly
swing violently. The effect of varying risk attitude is smaller but still non-negligible.
Overall, this analysis provides a theoretical interpretation for how mood fluctuations influence asset pricing, and it
suggests that considering investor mood in asset-pricing models can help interpret the growing body of seemingly anomalous
evidence in financial markets. As human behavior is motivated by both thought and feelings, neither should be ignored in
financial decision-making. The results of this study suggest that equally weighting thoughts and feelings goes a long way
toward interpreting investor behavior. However, for an enhanced understanding of how investor mood affects financial asset
prices, further study is needed to determine what influences investor mood and emotion, how mood fluctuations spread,
and why mood influences investor attention to certain groups of stocks. Further, if investor mood can predict asset price
movements, it may be possible to measure overall investor mood in advance to predict market prices. If so, investors can
benefit from exploiting the prediction. Thus, designing and developing a measurement method is a promising area of future
research.

Appendix A.

A.1. Derivation of expressions (10) and (11)

If Y follows the lognormal distribution with expected value  and variance h2 , then it is stated as: Y∼LN (,h) for brevity.
For a fixed value of parameter , the expected value of Y is:
 2 h2
E[Y  ] = e+ 2 (A1)

As x ∼ LN(u − (1/2) 2 , ), then use (A1), it is obtained that

2 2 2  2 2 2
(u− 2 )+  2 +  2

E(xt+1 )=e = eu− 2 (A2)

Thus, substituting  = − ˛ into (A2) yields

˛ 2 2 2
+ ˛ 2
−˛
E(xt+1 ) = e−˛u+ 2 (A3)

Then substituting (A3) into (7) yields the desired expression (10), and substituting (A3) into (8) yields the desired
expression (11).

A.2. Derivation of expression (15)

From (12), we have

 (1 + w 
t+1 )xt+1
E(Rt+1 ) = Et (A4)
wt
Because price-dividend ratio is i.i.d., then substitute (13) into (A4) yields
1 E(xt+1 )
E(Rt+1 ) = × (A5)
ˇ yt+1

Substituting  = 1 − ˛ into (A2) yields:

˛ 2
1−˛
yt+1 = E(xt+1 ) = e(1−˛) (u− 2
)
(A6)

As
2
E(xt+1 ) = eu− 2 (A7)

then, substituting (A6) and (A7) into (A5) yields expression (15).
 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282 281

References

Allen, A.M., Fisher, G.J., 1978. Ambient temperature effects on paired associate learning. Ergonomics 21, 95–101.
Anderson, C.A., 2001. Heat and violence. Current Directions in Psychological Science 10, 33–38.
Ariel, R.A., 1990. High stock returns before holidays: existence and evidence on possible causes. Journal of Finance 45, 1611–1626.
Au, K., Chan, F., Wang, D., Vertinsky, I., 2003. Mood in foreign exchange trading: cognitive processes and performance. Organizational Behavior and Human
Decision Processes 91, 322–338.
Baron, R.A., Ransberger, V.M., 1978. Ambient temperature and the occurrence of collective violence: the long, hot summer revisited. Journal of Personality
and Social Psychology 36, 351–360.
Becker, G.S., Mulligan, C.B., 1997. The endogenous determination of time preference. Quarterly Journal of Economics 112, 729–758.
Cao, M., Wei, J., 2005. Stock market returns: a note on temperature anomaly. Journal of Banking & Finance 29, 1559–1573.
Chang, T., Nieh, C.C., Yang, M.J., Yang, T.Y., 2006. Are stock market returns related to the weather effects? Empirical evidence from Taiwan. Physica A 364,
343–354.
Chopra, N., Lee, C.M.C., Shleifer, A., Thaler, R., 1993. Yes, discounts on closed-end funds are a sentiment index. Journal of Finance 48, 801–808.
Conlisk, J., 1996. Why bounded rationality? Journal of Economic Literature 34, 669–700.
Cunningham, M.R., 1979. Weather, mood and helping behavior: quasi-experiment with the sunshine Samaritan. Journal of Personality and Social Psychology
37, 1947–1956.
Daniel, K., Hirshleifer, D., Teoh, S.H., 2002. Investor psychology in capital markets: evidence and policy implications. Journal of Monetary Economics 49,
139–209.
Dowling, M., Lucey, B.M., 2005. Weather, biorhythms, beliefs and stock returns – some preliminary Irish evidence. International Review of Financial Analysis
14, 337–355.
Eagles, J.M., 1994. The relationship between mood and daily hours of sunlight in rapid cycling bipolar illness. Biological Psychiatry 36, 422–424.
Estrada, C.A., Isen, A.M., Young, M.J., 1997. Positive affect facilitates integration of information and decreases anchoring in reasoning among physicians.
Organizational Behavior and Human Decision Processes 72, 117–135.
Etzioni, A., 1988. Normative-affective factors: towards a new decision-making model. Journal of Economic Psychology 9, 125–150.
Falato, A., 2009. Happiness maintenance and asset prices. Journal of Economic Dynamics and Control 33, 1247–1262.
Finucane, M.L., Alhakami, A., Slovic, P., Johnson, S.M., 2000. The affect heuristic in judgments of risks and benefits. Journal of Behavioral Decision Making
13, 1–17.
Forgas, J.P., 1995. Mood and judgment: the affect infusion model (AIM). Psychological Bulletin 117, 39–66.
Forgas, J.P., 1998. On being happy and mistaken: mood effects on the fundamental attribution error. Journal of Personality and Social Psychology 75,
318–331.
Forgas, J.P., Ciarrochi, J., 2001. On being happy and possessive: the interactive effects of mood and personality on consumer judgments. Psychology and
Marketing 18, 239–260.
Frijda, N., 1988. The laws of emotion. Cognition and Emotion 1, 235–258.
Goldstein, K.M., 1972. Weather, mood, and internal–external control. Perceptual Motor Skills 35, 786.
Hanoch, Y., 2002. Neither an angel nor an ant: emotion as an aid to bounded rationality. Journal of Economic Psychology 23, 1–25.
Hirshleifer, D., 2001. Investor psychology and asset pricing. Journal of Finance 64, 1533–1597.
Hirshleifer, D., Shumway, T., 2003. Good day sunshine: stock returns and the weather. The Journal of Finance 58, 1009–1062.
Howarth, E., Hoffman, M.S., 1984. A multidimensional approach to the relationship between mood and weather. British Journal of Psychology 75, 15–23.
Isen, A.M., 2001. Some perspectives on positive affect and self-regulation. Psychological Inquiry 11, 184–187.
Isen, A.M., Geva, N., 1987. The influence of positive affect on acceptable level of risk: the person with a large canoe has a large worry. Organizational Behavior
and Human Decision Processes 39, 145–154.
Johnson, E.J., Tversky, A., 1983. Affect, generalization and the perception of risk. Journal of Personality and Social Psychology 45, 20–31.
Kamstra, M.J., Kramer, L.A., Levi, M.D., 2003. Winter blues: a SAD stock market cycle. The American Economic Review 93, 324–343.
Kamstra, M.J., Kramer, L.A., Levi, M.D., 2000. Losing sleep at the market: the daylight-savings anomaly. The American Economic Review 90, 1005–1011.
Kaufman, B.E., 1999. Emotional arousal as a source of bounded rationality. Journal of Economic Behavior and Organization 38, 135–144.
Keef, S.P., Roush, M.L., 2007. Daily weather effects on the returns of Australian stock indices. Applied Financial Economics 17, 173–184.
Keller, M.C., Fredrickson, B.L., Ybarra, O., Coˆteı̌, S., Johnson, K., Mikels, J., Conway, A., Wager, T., 2005. A warm heart and a clear head. Psychological Science
16, 724–731.
Krivelyova, A., Robotti, C., 2003. Playing the field: geomagnetic storms and international stock markets. Working paper, Federal Reserve Bank of Atlanta.
Lee, C., Shleifer, A., Thaler, R., 1991. Investor sentiment and the closed-end fund puzzle. Journal of Finance 46, 75–109.
Lo, A.W., Repin, D.V., 2002. The psychophysiology of real-time financial risk processing. Journal of Cognitive Neuroscience 14, 323–339.
Loewenstein, G.F., 1996. Out of control: visceral influences on behavior. Organizational Behavior and Human Decision Processes 65, 272–292.
Loewenstein, G.F., 2000. Emotions in economic theory and economic behavior. The American Economic Review 65, 426–432.
Loewenstein, G.F., Hsee, C.K., Weber, E.U., Welsh, N., 2001. Risk as feelings. Psychological Bulletin 127, 267–286.
Loewenstein, G., O’Donoghue, T., Rabin, M., 2003. Projection bias in predicting future utility. Quarterly Journal of Economics 118, 1209–1248.
Loewenstein, G., Prelec, D., 1992. Anomalies in intertemporal choice: evidence and an interpretation. Quarterly Journal of Economics 107, 573–597.
Lucas, R.E., 1978. Asset prices in an exchange economy. Econometrica 46, 1429–1445.
Lucey, B.M., Dowling, M., 2005. The role of feelings in investor decision-making. Journal of economic surveys 19, 211–237.
MacGregor, D.G., Slovic, P., Dreman, D., Berry, M., 2000. Imagery, affect, and financial judgment. Journal of Psychology and Financial Markets 1, 104–110.
Mann, L., 1992. Stress, affect, and risk taking. In: Yates, J.F. (Ed.), Risk-taking Behavior. Wiley, New York, pp. 201–230.
Mehra, R., 2003. The equity premium: why is it a puzzle? Financial Analysts Journal 59, 54–69.
Mehra, R., Sah, R., 2002. Mood, projection bias and equity market volatility. Journal of Economic Dynamics and Control 26, 869–887.
Nofsinger, J.R., 2005. Social mood and financial economics. The Journal of Behavioral Finance 6, 144–160.
Nygren, T.E., Isen, A.M., Taylor, P.J., Dulin, J., 1996. The influence of positive affect on the decision rule in risk situations: focus on outcome (and especially
avoidance of loss) rather than probability. Organizational Behavior and Human Decision Processes 66, 59–72.
Parrott, W.G., Sabini, J., 1990. Mood and memory under natural conditions: evidence for mood incongruent recall. Journal of Personality and Social Psychology
59, 321–336.
Persinger, M.A., 1975. Lag responses in mood reports to changes in the weather matrix. International Journal of Biometeorology 19, 108–114.
Pilcher, J.J., Eric, N., Busch, C., 2002. Effects of hot and cold temperature exposure on performance: a meta-analytic review. Ergonomics 45, 682–698.
Rotton, J., Cohn, E.G., 2000. Violence is a curvilinear function of temperature in Dallas: a replication. Journal of Personality and Social Psychology 78,
1074–1081.
Samuelson, P.A., 1937. A note on the measurement of utility. The Review of Economic Studies 4, 155–161.
Sanders, J.L., Brizzolara, M.S., 1982. Relationships between mood and weather. Journal of General Psychology 107, 157–158.
Saunders Jr., E.M., 1993. Stock prices and Wall Street weather. The American Economic Review 83, 1337–1345.
Schneider, F.W., Lesko, W.A., Garrett, W.A., 1980. Helping behavior in hot, comfortable and cold temperature: a field study. Environment and Behavior 2,
231–261.
Schwarz, N., 1990. Feelings as information: informational and motivational functions of affective states. In: Higgins, E.T., Sorrentino, R.M. (Eds.), Handbook
of Motivation and Cognition: Foundations of Social Behavior, vol. 2. Guilford, New York, pp. 527–561.
282 H.-C. Shu / Journal of Economic Behavior & Organization 76 (2010) 267–282

Schwarz, N., Bless, H., 1991. Happy and mindless, but sad and smart? The impact of affective states on analytic reasoning. In: Forgas, J. (Ed.), Emotion and
Social Judgment. Pergamon, Oxford, pp. 55–71.
Schwarz, N., Clore, G.L., 1983. Mood, misattribution, and judgments of well-being: informative and directive functions of affective states. Journal of
Personality and Social Psychology 45, 513–523.
Shu, H.C., Hung, M.W., 2009. Effect of wind on stock market returns: evidence from European markets. Applied Financial Economics 19, 893–904.
Thaler, R., Johnson, E., 1990. Gambling with the house money and trying to break even: the effects of prior outcomes on risky choice. Management Science
36, 643–660.
Watson, D., 2000. Mood and temperament. Guilford Press, New York.
Wright, W.F., Bower, G.H., 1992. Mood effects on subjective probability assessment. Organizational Behavior and Human Decision Processes 52, 276–291.
Yuan, K., Lu, Z., Zhu, Q., 2006. Are investors moonstruck? Lunar phases and stock returns. Journal of Empirical Finance 13, 1–23.