Optimism, Volatility and Decision-Making in Stock Markets
31 Pages Posted: 22 Jun 2017 Last revised: 21 Apr 2018
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: Suggested Citation