Behavioural Finance

Seminar 4:
Revision of Lecture 4:
Emotional finance
Physiological finance
Dr Daphne Sobolev
Behavioural Finance: Lecture 4, Part 2

• Lecture 1: Introduction to Social Psychology and Cognitive Psychology

• Lecture 2: Foundations of behaviour:
Challenging the classical assumptions of finance
• Lecture 3: Central behavioural finance effects
• Lecture 4: Emotional and physiological finance
• Lecture 5: Happiness and well-being in the financial industry
• Lecture 6: The relationship between clients, financial practitioners and
institutions
• Lecture 7: Understanding bank clients’ behaviour
• Lecture 8: Financial crime
• Lecture 9: Ethics and Finance
• Lecture 10: The new frontiers of Behavioural Finance
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Lecture 4: Contents

Introduction: Rational vs. intuitive decision making models

Emotional Finance

Physiological finance

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Rational decision making process
Identify the Establish
problem decision
Evaluate the criteria
decision

Implement Weigh
the decision
decision criteria
Choose the
best Generate
alternative Evaluate the alternatives
alternatives
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Did people make decisions rationally during
the beginning of the COVID-19 pandemic?

https://untappedcities.com/2020/03/25/daily-
Page 5 coronavirus-news-update-nyc-parks-might-close-
car-free-streets-coming/
Introduction: Rational vs. intuitive decision making
models
Sloman, S. A. (2002). Two systems of reasoning. In Heuristics and Biases:
The Psychology of Intuitive Judgment (Gilovich, T. and Griffin, D., eds),
379–396, Cambridge University Press.

Main idea: People have two systems for decision-making:

• Rational system – slow, based on algorithms and deliberation
• Intuitive system – fast, uses emotions and heuristics

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Emotion effects on financial behaviour
Duxbury, D. (2015). Behavioral finance: Insights from experiments II:
Biases, moods and emotions. Review of Behavioral Finance, 7(2), 151-
175.

1. Analysis of market data

Mood proxies used in empirical research draw on results from
Psychology:
• Weather and temperature
• Hours of daylight and seasonal affective disorder (SAD)
• Sporting events
• Large scale aviation disasters
• Lunar phases (???)

Main results: Investor sentiment affects market behaviour

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 Emotion effects on financial behaviour:
Research streams
2. Surveys
Kaplanski, G., Levy, H., Veld, C., & Veld-Merkoulova, Y. (2015). Do happy
people make optimistic investors? Journal of Financial and Quantitative
Analysis, 50(1-2), 145-168.
• Main hypothesis: The better the individual’s general feeling, the higher the
expected return.

• Data: Large scale surveys of hundreds of participants in the Netherlands

• Questions:
• Subjective general feeling: very bad -1 to great – 5
• Short-term, next-month expectations and their longer-term, next year
expectations of the the Amsterdam Exchange Index (AEX) and the S&P 500
• Past and future investment plans
• Main result: Happiness is positively related
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with return expectations
Emotion effects on financial behaviour:
Research streams

3. Experiments

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(2), 322-338.

Main hypothesis:
Participants in a pleasant mood perform worse in financial tasks than
those in neutral and unpleasant moods.

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…Au et al. (2003): Method

Mood manipulation
Participants mood was induced by the following manipulation:
• Positive or negative performance feedback during a task prior to the
main simulation task
• Pleasant or unpleasant music or no music (neutral) during all rounds of
trading
• Exposure to pleasant or unpleasant sentences

Experimental task: participants made decisions whether to buy or sell

currencies.

Main result: Mood affected decision accuracy!

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How does fear affect trading behaviour?
Lee, C., & Andrade, E. (2011). Fear, social
projection, and financial decision making.
Journal of Marketing Research, 48, S121.

Emotional manipulation
• Control condition: participants watched
scenes from two documentaries were
presented (Benjamin Franklin and Vincent
Van Gogh)
• Fear condition: participants watched scenes
from two horror movies (The Sixth Sense
and The Ring).
Task
“Cash-out game” – participants made
buy/hold decision in each round Page 11
Which other emotions may affect investors’
decisions?
Peifer, J. (2014). Fund loyalty among socially responsible investors: The
importance of the economic and ethical domains. Journal of Business
Ethics, 121(4), 635-649.
Main results: dual investors (- those who invest in both SR and
conventional funds) are more loyal to their SR fund than to their
conventional fund.

Aspara, J. & Tikkanen, H. (2011). Individuals’ affect-based motivations to

invest in stocks: beyond expected financial returns and risks. Journal Of
Behavioral Finance, 12(2), pp.78–89.
Main result: Investors invest in stocks that they like!

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Investment strategies can be based on knowledge of
investor emotions!
Kim, J. S., Ryu, D., & Seo, S. W. (2014). Investor sentiment and return
predictability of disagreement. Journal of Banking and Finance, 42(1),
166-178.

“We suggest a profitable trading strategy based on disagreement and

investor sentiment.”

• Disagreement among analysts’ opinions:

The standard deviation of analysts’ forecasts of the long term earning-per-
share growth rate, weighed with respect to the market capitalization of the
stocks.
• Market sentiment:
The measure of Baker and Wurgler (2007): based on residuals after
regression of financial data with respect to macroeconomic information.
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Kim, Ryu and Seo (2014): Trading strategy

• Findings:
• During high-sentiment periods:
• Higher disagreement among analysts’ opinions predicts
significantly lower future stock market returns
• During low-sentiment periods:
• No such effect

 Shorting trading strategy, which is based on market sentiment and

disagreement should work

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Kim, Ryu and Seo (2014): Conclusion
“We confirm that the trading strategy exploiting disagreement along with
the level of investor sentiment is more profitable than the buy-and-hold
strategy in the stock market.” (p.176)

https://money.howstuffworks.com/how-much-money-is-in-the-world.htm
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The case of COVID-19

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 … The case of Covid-19

https://www.oecd.org/coronavirus/policy-responses/global-financial-markets-policy-responses-to-covid-19-2d98c7e0/ Page 17
How did COVID-19 affect market sentiment?
Fallahgoul, H. (2020). Inside the mind of investors during the COVID-19
pandemic: Evidence from the StockTwits data. Available on
https://arxiv.org/abs/2004.11686.
Research method:
• A comprehensive analysis of all posted messages on the StockTwits
platform in 2020, including 3,676,169 messages of 179,468 unique users
mentioning 10,715 unique tickers.
• Data analysis:
➢Natural Language Processing (NLP) techniques
➢Investors’ classification of their messages into bearish / bullish
• Investor philosophies (approach, trading horizon, experience level) were
examined through the investors’ StockTwits profiles
▪ Results: Between February 19, 2020, and March 23, 2020:
• Investors’ sentiment decreased
• Investors’ disagreement had an increased
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Was the markets’ response to Covid-19 financially
rational or due to market sentiment?

Sun, Y., Wu, M., Zeng, X., & Peng, Z. (2021). The impact of COVID-19 on
the Chinese stock market: Sentimental or substantial? Finance Research
Letters, 38, 101838.

According to the EMH: The financial response is rational if it resulted from

corresponding economic loss
The firms in regions with more confirmed Covid-19 cases should suffer
more than firms in other regions
The stock returns of firms in Hubei Province should be lower than the
average
The gap should grow as the situation in Hubei became worse
The abnormal returns of pharmaceutical companies should be greater
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Sun et al. (2021): Results

• The pandemic has an overall negative effect on stock market during the
post-event window
• The negative effect on the market cannot be explained only real
economic losses
• Market sentiment affected the losses
• There was a stronger positive correlation between individual investor
sentiment and stock returns than usual
• Only industries related to pharmacy, digitalization and agriculture did
better during the pandemic

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How did governments’ policies affect the markets?
Narayan, P. K., Phan, D. H. B., & Liu, G. (2021). COVID-19 lockdowns,
stimulus packages, travel bans, and stock returns. Finance Research
Letters, 38, 101732.

Governments responded with a range of policies to the pandemic:

Lockdowns: Restricting people’s movement
Travel bans: Closing international borders
Stimulus packages: Supporting workers and businesses
Research question: How did the market react to each of these policies in
the G7 countries?

Results: Lockdowns had the strongest positive effects, followed by

stimulus packages and travel bans.

Explanation: Governments policies affected investor sentiment

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Applications for future finance practitioners?

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How do financial practitioners work in the financial
markets?

1. The role of emotional regulation

 Fenton‐O'Creevy, M., Soane, E., Nicholson, N., & Willman, P. (2011).
Thinking, feeling and deciding: The influence of emotions on the
decision making and performance of traders. Journal of Organizational
Behavior, 32(8), 1044-1061.

Emotion regulation: the ability to deal with emotions and continue

behaving in an adequate way, while delaying spontaneous reactions.

• In finance, following emotions is usually related to biases

• However, emotions can be regarded as a source of information.
• Traders can either ignore them, or use them.
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Fenton-O'Creevy et al (2011) : Method
• Location: Four investment banks in the City of London

• Research method used: interviews and collection of data about

performance
• Interview duration: 30 - 90 minutes
• Questions:
• The range of emotions traders experienced during trading
• The long-term and short term effects of emotions on their decision
making and trading strategy
• The role of intuition in their trading
• The impact of emotions on performance
• Performance data:
• Income and bonus
• Managers’ evaluations
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Fenton-O'Creevy et al (2011): Results

1. Investors experience large mood swings

2. Non-relevant emotions such a s mood swings due to market behaviour
have a strong effect on traders’ decisions
3. Emotional regulation is correlated with experience and pay
4. Affective cues (e.g. ‘gut feeling’, ‘it felt right’) have an important role in
traders’ behaviour

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How do financial practitioners work in the financial
markets?

2. The search for meaning

 Taffler, R. J., & Tuckett, D. (2012). Fund management: an emotional
finance perspective. UK: Research Foundation of CFA Institute

• Investors have to deal with huge information volumes and uncertainty

• How can they arrive at the conviction required to act in the way they
choose, sometimes facing great losses?
• Research method: Interviews with investors and managers.
• Answer: Investors develop meta-narratives
• Meta-narratives: Investors’ beliefs, according to which they trade.

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Trust behaviour

How do people perceive their financial advisors?

Gennaioli, N., Shleifer, A., & Vishny, R. (2015). Money doctors. Journal of
Finance, 70(1), 91-114.

People think about financial advisors similarly to the way that they think
about medical doctors:
• Many times investors do not know how to invest (like patients do not
know how to treat themselves)
• Financial advisors help investors make risky decisions (like doctors
prescribe treatments)
• Investors trust their advisors although their advice is often costly, generic
and self-serving (like patients trust their doctor)

* Research method: Market model

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Main results from trust experiments

▪ Berg et al. (1995):

— People usually choose to trust
others and behave in a
trustworthy manner.
▪ People tend to trust others even if:
— They are strangers
— The situation is unfamiliar
— With no investigation
▪ Fehr (2009):
— If people learn that the other
person is not trustworthy – they
stop behaving in a trustful way.

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Rational and irrational elements in trust

1. Transparency increases trusting behaviour

2. Repeated interaction increases trust and reciprocity with or without
transparency.
3. Channel of communication (personal / firm twitter account)

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Physiological finance:
Neurofinance

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Kuhnen, C.M. & Knutson, B. (2005). The neural
basis of financial risk taking. Neuron, 47(5), 763–
770.
Research question: Why do individual investors systematically deviate
from optimal behaviour?

Hypothesis: neural activation linked to anticipatory affect predict financial

choices
 Positive feelings linked to anticipation of gain (“excitement”) promote
risk taking
 Negative feelings linked to anticipation of loss (“anxiety”) promote risk
aversion

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Kuhnen and Knutson (2005): Experimental design

• Independent variable: participants’ anticipation (gains / losses)

• The IV was manipulated by showing participants outcomes of 2 stocks
(good, bad) and a bond at each trial:
• Outcomes of the good stock:
— +$10 with 50% probability
— +$0 with 25% probability,
— −$10 with 25% probability
• outcomes of the bad stock:
— +$10 with 25% probability
— +$0 with 25% probability
— −$10 with 50% probability
• Dependent variable: participants’ brain activity
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Kuhnen and Knutson (2005): Experimental
procedure

Participants were asked to complete a dynamic

investment task while being in an fMRI

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Kuhnen and Knutson (2005): Results
▪ Nucleus accumbens
activation preceded
risky choices as well as
risk-seeking mistakes
▪ Anterior insula
activation preceded
riskless choices as well
as risk-aversion
mistakes
From different studies:
Nucleus accumbens is
related to feelings of  Risky behaviour may be the result of
expected rewards anticipated rewards
Anterior insula – related  Riskless behaviour may be the
to anxiety, disgust results
Page 34 of anxiety
Kuhnen and Knutson (2005): Conclusion

Neural circuits linked to anticipatory affect promote

different types of financial choices

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References
▪ 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(2), 322-338.
▪ Berg, Dickhaut, & Mccabe. (1995). Trust, Reciprocity, and Social History. Games
and Economic Behavior, 10(1), 122-142.
▪ Duxbury, D. (2015). Behavioral finance: Insights from experiments II: Biases,
moods and emotions. Review of Behavioral Finance, 7(2), 151-175.
▪ Elliott, W., Grant, S., & Hodge, F. (2018). Negative news and investor trust: The
role of $firm and #CEO Twitter use. Journal of Accounting Research, 56(5), 1483-
1519.
▪ Fehr, E. (2009). ON THE ECONOMICS AND BIOLOGY OF TRUST. Journal of the
European Economic Association, 7(2‐3), 235-266.
▪ Fenton‐O'Creevy, M., Soane, E., Nicholson, N., & Willman, P. (2011). Thinking,
feeling and deciding: The influence of emotions on the decision making and
performance of traders. Journal of Organizational Behavior, 32(8), 1044-1061.
▪ Gennaioli, N., Shleifer, A., & Vishny, R. (2015). Money doctors. Journal of
Finance, 70(1), 91-114. 36
Page
…References
▪ Kanagaretnam, Mestelman, Nainar, & Shehata. (2010). Trust and reciprocity with
transparency and repeated interactions. Journal of Business Research, 63(3),
241-247.
▪ Kim, J. S., Ryu, D., & Seo, S. W. (2014). Investor sentiment and return
predictability of disagreement. Journal of Banking and Finance, 42(1), 166-178.
▪ Knewtson, & Sias. (2010). Why Susie owns Starbucks: The name letter effect in
security selection. Journal of Business Research, 63(12), 1324-1327.
▪ Kuo, W., Sjöström, T., Chen, Y., Wang, Y., & Huang, C. (2009). Intuition and
deliberation: Two systems for strategizing in the brain. Science (New York, N.Y.),
324(5926), 519-22.
▪ Lee, C., & Andrade, E. (2011). Fear, social projection, and financial decision
making. Journal of Marketing Research, 48, S121.
▪ Lo, A.W., & Repin, D.V. (2002). The psychophysiology of real-time financial risk
processing. Journal of Cognitive Neuroscience,14(3), 323-339.
▪ Mackay, C., & De La Vega, J. (1996). Extraordinary popular delusions and the
madness of crowds; Confusion of confusions. New Yor, NY: Wiley Investment
Classics. Page 37
…References
▪ Peifer, J. (2014). Fund loyalty among socially responsible investors: The
importance of the economic and ethical domains. Journal of Business Ethics,
121(4), 635-649.
▪ Sloman, S. A. (2002). Two systems of reasoning. In Heuristics and Biases: The
Psychology of Intuitive Judgment (Gilovich, T. and Griffin, D., eds), 379–396,
Cambridge University Press.
▪ Taffler, R. J., & Tuckett, D. (2012). Fund management: an emotional finance
perspective. UK: Research Foundation of CFA Institute
▪ Tsai, M.-H. and Young, M.J. (2010). Anger, fear, and escalation of commitment.
Cognition and Emotion, 24(6), 962-973.
▪ Tuckett, D. (2011). Minding the markets: An emotional finance view of financial
instability. New York, NY: Palgrave Macmillan.
▪ Xing, X., Anderson, R. I., & Hu, Y. (2016). What‫׳‬s a name worth? The impact of a
likeable stock ticker symbol on firm value. Journal of Financial Markets, 31, 63-
80.

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