Financial Update (Third Quarter 2003)


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Can Emotion Affect Financial Markets?

Can Emotion Affect Financial Markets?

Psychologists and economists hold vastly different views about human behavior. Psychologists contend that economists’ models bear little relation to actual behavior. This view is supported by a large body of psychological research that shows that emotional state can significantly affect decision making.

Economists, on the other hand, argue that psychological studies have no theoretical basis and offer little empirical evidence about people’s decision-making processes. The reigning financial economics paradigm — the efficient market hypothesis (EMH) — assumes that individuals make rational investment decisions using the rules of probability and statistics. A newer branch of financial economics called behavioral finance applies lessons from psychology to financial decision making, but most of these studies have focused on cognitive biases rather than emotion.

An Atlanta Fed Economic Review article by Lucy F. Ackert, Bryan K. Church and Richard Deaves argues that emotion has important, and possibly beneficial, influences on financial behavior. After defining the term emotion and describing how emotions can be categorized, the authors consider how emotions influence human behavior. The discussion focuses particularly on three aspects of emotion and financial decision making: emotional disposition and stock market pricing, the feeling of regret, and investors’ emotional response to information.

No new financial economics paradigm that incorporates behavioral influences and better models actual behavior has yet emerged to replace the EMH. Yet the authors believe that emotional behavior’s influence on financial decision making should be taken into account in future research.

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