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Happiness Maintenance and Asset Prices

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  • Antonio Falato

    (Columbia University)

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.

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File URL: http://128.118.178.162/eps/fin/papers/0310/0310003.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0310003.

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Date of creation: 02 Oct 2003
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Handle: RePEc:wpa:wuwpfi:0310003

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Web page: http://128.118.178.162

Related research

Keywords: consumption-based asset pricing behavioral finance state- dependent risk aversion equity premium puzzle affect and decision making;

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References

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Citations

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Cited by:
  1. Pascal St-Amour, 2004. "Ratchet vs Blasé Investors and Asset Markets," CIRANO Working Papers 2004s-11, CIRANO.
  2. Danthine, Jean-Pierre & Donaldson, John B & Giannikos, Chrisos & Guirguis, Hany, 2003. "On the Consequences of State Dependent Preferences for the Pricing of Financial Assets," CEPR Discussion Papers 3697, C.E.P.R. Discussion Papers.
  3. John Donaldson & Rajnish Mehra, 2007. "Risk Based Explanations of the Equity Premium," NBER Working Papers 13220, National Bureau of Economic Research, Inc.
  4. Pascal St-Amour, 2005. "Direct Preference for Wealth in Aggregate Household Portfolio," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 05.04, Université de Lausanne, Faculté des HEC, DEEP.
  5. Pascal St-Amour, 2005. "Direct Preference Wealth in Aggregate Household Portfolios," FAME Research Paper Series rp136, International Center for Financial Asset Management and Engineering.
  6. Antonio Falato, 2008. "Happiness maintenance and asset prices," Finance and Economics Discussion Series 2008-19, Board of Governors of the Federal Reserve System (U.S.).

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