I am now back in Germany and have officially completed the third year of my undergraduate degree at university! University is going to resume in September, meaning that I have July and August off to prepare for my final year and especially for my dissertation in Economics. As a dissertation topic I have chosen to focus on prospect theory in a macroeconomic setting. I hope to go into the direction of behavioural macroeconomics. In particular, I seek to apply reference dependence on risk taking and attempt to explain time varying risk preference through a change in the reference point over an economic cycle. To be honest, it is hard to pull together all my ideas at such an early stage but I think that prospect theory and behavioural economics has an enormous potential for making macroeconomics more realistic in modeling actual economic behaviour.
One of my readings for the influence of market sentiment on decision making is “Social Mood and Financial Economics” by John R. Nofsinger. In his paper Nofsinger puts forward three hypotheses: (1) Social mood determines the types of decisions made by economic actors, (2) the stock market is a direct measure of social mood, and (3) stock market trends can be deployed to forecast future financial and economic activity.
Importantly, Nofsinger argues that the economy is a complex system of human interactions. This implies that individuals’ feelings and thoughts enter the process of decision making and therefore ultimately influence their actions. Furthermore, under the assumption that the emotions or mood of the economic actors are correlated, the general level of optimism or pessimism in society can trigger macroeconomic phenomena. Essentially, what this means is that market sentiment is an important driver of economic activity. Optimism likely leads to overconfidence and risk taking while pessimism induces risk averse or at least more conservative behaviour. Hence optimism ultimately increases the size of the economy and pessimism reduces the size of the economy and therefore market sentiment has real and sizeable effects on the economy.
Nofsinger points out that human interactions, which is the way “how people share information and communicate emotion and mood” (p.145), lead to a shared attitude in society. What is more, in today’s society rapid communication reinforces this convergence towards a uniform attitude or social mood even faster. This implies that market sentiment becomes even more important with increased interconnectivity and continuous global communication.
In addition to this background mood there is a role for emotions at the point of decision making as well as a role for anticipated emotions accompanied by the anticipated outcomes. Overall it can be said that the more complex a decision, the more likely it is that an individual relies on his or her gut feeling. Emotions in decision making under risk or uncertainty pose an easy shortcut to make a decision.
At the heart of Nofsinger’s paper is the theory of social mood and the social mood cycle. Nofsinger proposes that shared beliefs lead to social trends and that therefore the level of social mood has an important influence on the economy. In particular, he argues that positive moods trigger productive economic activity while negative moods do not trigger such but unproductive economic activity instead. Hence by observing the collective behaviour of economic actors one can make conclusions about the aggregate level of social mood. Economic activity is a good proxy for the actors’ aggregate mood.
The first prediction of Nofsinger’s theory is that social mood determines the types of decisions economic actors make. Optimism induces investors to hold higher-risk portfolios and to trade more, consumers to spend more and to borrow more, as well as businesses to increase their investments and turn to debt financing. One is also likely to observe an increase in the amount of mergers and the number of business start-ups. In contrast, pessimism induces a higher market volatility and investors to hold lower-risk portfolios. Consumers are likely to spend less and to borrow less or even pay down their accumulated debt and deleverage. In a pessimistic market businesses invest less, there are likely to be few mergers and restructuring and cost-cutting are likely to be on the agenda of firms rather than expansion. In sum, the level of social mood drives the nature of the decisions made by economic actors.
The second prediction of Nofsinger’s theory is that “due to the efficient and emotional nature of stock market transactions, the stock market itself is a direct gauge of social mood” (p.147). For this Nofsinger analyses the equity premium, market volatility, bubbles and investor sentiment.
The third prediction of Nofsinger’s theory is that “since the tone and character of business activity follows rather than leads social mood, stock market trends help forecast future financial and economic activity” (p.148). For this Nofsinger analyses corporate finance with corporate executive behaviour, mergers, initial public offerings, and entrepreneurs’ decisions to start new businesses.
Overall I think that the paper will prove valuable for my dissertation because Nofsinger concludes that “peaking mood fosters risk-seeking behaviour” (p.158), including excessive borrowing and overinvesting. The paper can therefore support my idea to explain changing risk preference with changes in aggregate market sentiment. In addition, I will probably use Nofsinger’s view of the economy as a complex system of human interactions for my second hypothesis, namely arguing that the economy should be viewed as an open social system. The idea is that the state of the macro-economy influences microeconomic behaviour of investors and consumers which in turn influences the macroeconomic system. Recognising this interaction implies a closed loop.
Many thanks for reading today’s post. Nofsinger’s paper can be found here and I hope you enjoy the read!
Nofsinger, J.R. (2005). Social Mood and Financial Economics. Journal of Behavioural Finance, 6(39), pp.144-160.