An Alternative Approach to Measuring Financial Investor Decision Making

Abstract

We propose a novel methodology to characterize the investor decision making process. By drawing logical paths in a structural equation model (SEM) framework, we uncover the role of a latent financial risk index that is simultaneously shaping the dynamics of different financial asset prices. Our methodology allows for disentangling the different components of asset prices – those driven by fundamental and non-fundamental variables. We apply this methodology to the Euro area stock and sovereign bond markets over the 2003-2014 period. Lower economic and political uncertainty in Europe lights up appetite for stocks and away from bonds, while U.S. Quantitative Easing is shown to have boosted European stocks.

Keywords: Structural Equation Model, Risk Appetite, Latent Index, Europe

JEL Classification: C30, G11, G12