Optimism, Volatility and Decision-Making in Stock Markets

31 Pages Posted: 22 Jun 2017 Last revised: 21 Apr 2018

See all articles by Francesco Rocciolo

Francesco Rocciolo

Imperial College Business School

Andrea Gheno

University of Rome III - Department of Business Studies

Chris Brooks

University of Bristol - School of Economics, Finance and Management

Date Written: April 13, 2018

Abstract

In this paper we introduce a new, analytically tractable model for decision-making under risk in which psychological characteristics related to the degree of optimism or pessimism of the decision-maker are considered. The model 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 framework. 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.

Keywords: Optimism, Decision-Making, Financial Markets

JEL Classification: G02, G11, G12

Suggested Citation

Rocciolo, Francesco and Gheno, Andrea and Brooks, Chris, Optimism, Volatility and Decision-Making in Stock Markets (April 13, 2018). Available at SSRN: https://ssrn.com/abstract=2990659 or http://dx.doi.org/10.2139/ssrn.2990659

Francesco Rocciolo (Contact Author)

Imperial College Business School ( email )

South Kensington Campus,
Exhibition Rd
London, SW72AZ
United Kingdom

Andrea Gheno

University of Rome III - Department of Business Studies ( email )

Department of Business Studies
Via Silvio D'Amico 77
Roma, RM 00145
Italy

Chris Brooks

University of Bristol - School of Economics, Finance and Management ( email )

School of Accounting and Finance
15-19 Tyndalls Park Road
Bristol, BS8 1PQ
United Kingdom

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