Happiness Maintenance and Asset Prices

Antonio Falato ()

Finance from University Library of Munich, Germany

Abstract: This paper explores the implications of investors’ everyday mild feelings for aggregate asset returns. To this end, it introduces a novel class of state dependent preferences - happiness maintenance preferences - into the standard Mehra and Prescott (1985) economy by allowing investors’ coefficient of relative risk aversion to depend partly on their current feelings, which, in turn, are a function of the current state of the economy. Consistent with recent evidence from experimental psychology (see for example Isen (1999)), good times bring about a positive mood for investors and a heightened pain from any potential loss. In an attempt to maintain their good mood, investors become less willing to bear any portfolio risk, i.e. they become more risk averse. Extremely mild procyclical changes (a standard deviation of about one percentage point) in investors’ risk aversion are sufficient to bring the implications of a simple dynamic model of asset pricing in line with the historically observed stylized features of asset returns, without relying on unreasonable values of the behavioral parameters. With a realistic consumption process, the model is capable of accounting for a sizable equity premium in line with the one observed in the US data. It also performs well with respect to other financial statistics, such as the average risk-free rate, the volatility and predictability of stock returns and the Sharpe ratio. Being able to match the equity premium, it implies that aggregate fluctuations have important welfare costs.

Keywords: consumption-based; asset; pricing; behavioral; finance; state-; dependent; risk; aversion; equity; premium; puzzle; affect; and; decision; making (search for similar items in EconPapers)
JEL-codes: D81 D91 E44 G12 (search for similar items in EconPapers)
Date: 2003-10-02
New Economics Papers: this item is included in nep-fin
Note: Type of Document - none; prepared on Pdf; to print on Pdf;
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Related works:
Journal Article: Happiness maintenance and asset prices (2009)
Working Paper: Happiness maintenance and asset prices (2008)
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0310003

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