Emotions component of

expectations in nancial
decision making
Jekaterina Kuzmina
BA School of Business and Finance, Riga, Latvia
Abstract
Purpose The economic system is an expectations feedback system, thus decisions made by
economic agents are based on their expectations about the future state of the economy. These decisions
affect actual realization of economic variables and this process leads to the new expectations. For a
long period of time, economics was based on the erroneous belief that economic agents apply rational
calculations to economic and nancial decisions. The main purpose of the current paper is to present
the theoretical model explaining emotions component of expectations in the process of nancial
decision making.
Design/methodology/approach The research is based on the generally accepted scientic
qualitative and quantitative methods, including monographic method.
Findings The paper shows how the expectations and subjective beliefs of different nancial
market participants could be translated into prices. After describing the main investors categories, it
is possible to model their subjective beliefs about the current price evolution on the stock exchange and
formulate the demand strategy of each investors group. Finally, the model shows mathematical
considerations how prices result from demands, considering that they are set by the market maker.
Originality/value The paper shows how emotions impact investors beliefs and could be
transmitted into prices. A particular agent category the emotional investor was formulated, who
exclusively follows his intuition and whose presence inuences market prices. So, there is no doubt that an
appropriate rational strategy requires the adoption to the new kind of market agent and theoretical
considerations presented in the paper could contribute to this process.
Keywords Expectational, Emotional intelligence, Prices, Financial markets, Financial modelling,
Decision making
Paper type General review
Introduction
The most commonly used theoretical assumption in the economic literature is that
every event could be described by efcient and easily tractable models. But the reality
claims that each occasion is more complex and less predictable than it was assumed in
advance, and that is why human beings as a most active part of this reality are highly
complex constructs. Until now, professionals are not been able to entirely recognize
and describe how human minds function, either to clarify and predict the outcome of
human decisions. Several examples from the history of humanity show that human
decisions fail to be rational as it is assumed in the economic models and it takes place
in particular in complex, dynamic, uncertain, or dense of information environments,
as for example nancial markets. Based on this evidence, it can be noticed that the
assumption of the models about economic agents (in the context of nancial markets:
investors and traders) being rational, able to use simultaneously all the information
available, to compute and evaluate possible risks and outcomes, and nally to make
The current issue and full text archive of this journal is available at
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Financial
decision making
295
Received September 2009
Revised April 2010
Accepted June 2010
Baltic Journal of Management
Vol. 5 No. 3, 2010
pp. 295-306
qEmerald Group Publishing Limited
1746-5265
DOI 10.1108/17465261011079721
fast decisions at no costs, is totally false. Even though most of economic models ignore
behavioral aspects of human decision making (even though it must be said that after
the work by Kahneman and Tversky (1979) was published, there are several attempts
to consider behavioral aspect in the economic models), the author strongly believes that
considering these aspects would contribute to better understanding of real
environment and in particular of nancial markets.
As the topic described above is of particular interest on the eld of nance, there are
several works done on the eld. Reinhart and Brennan (2004) are analyzing yield
development in the Behavioral-Finance-Funds, while they do concentrate only on the
performance, while no particular techniques are analyzed. Brozynski et al. (2003) and
Menkhoff and Schmidt (2005) describe in their papers the strategy chosen by
institutional investors. But most of the authors are concentrating on the strategy and
performance, while there is still little research done on the process of nancial decision
making.
The current paper is going to describe the role of emotions in the process of nancial
decision making and so to contribute to the theoretical considerations on the eld of
behavioral economics. Please note that the author is interested in the particular aspect of
the decision-making process emotional component and such aspects as for example
adaptive learning process (even though it is relevant in the process of expectations
formation and is wildly used) is not going to be described further. The rst part of the
paper is going to deal with describing and evaluating main ndings on emotions from
social science like psychology as human emotions are strongly related to human
decisions and that is why impacts trading decisions especially under time and
uncertainty pressure. The second part is going to describe the role of emotions in the
nancial market by creating a mathematical model considering different investors
categories: rational investor, emotional investor and nally noise investor (or more
commonly used noise trade, while taking into considerations that in the current paper
the word investor is going to be used in order to describe economic agent in the
nancial market), as each of them uses different methods of information evaluation and
acting on the nancial market. As a result, the change in assets prices on the nancial
markets is based not only on the information signals, but also on the investors emotions
about previous or future possible event.
Short overview about emotions and their role in the process of decision
making
In the rst part of the current paper, the author would like to describe the impact of
emotions in respect of decision making. It is important to underline that traditional
economic theory is only briey mentioning the existence and role of emotions claiming
the rationality of economic agent that is why the ndings from psychology should be
used. Damasio (1996) described emotions as a combination of simple and complex
mental evaluative process resulting in an emotional state of the body as additional
mental change. Emotions could be seen both as a reaction to the particular situation or as
a state of human brain preparing the body to react in one or an other way. Similar idea
was expressed also by Oatley and Jenkins (1996) and Frijda et al. (2000). It is important to
notice that most of the authors do not separate between feelings and emotions.
According to Damasio (1996) emotions could be classied in three categories:
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(1) Innate or primary emotions (like happiness, sadness, anger, or fear) are specic
reactions to particular stimuli. At physiological level, these emotions are
automaticallygenerated when the limbic systemidenties the respective stimulus.
For the humans innate emotions are followedbycorresponding feelings and canbe
predicted and controlled.
(2) Secondaryemotions (like euphoria, melancholy, and panic) are gained inthe course
of individual experience, while the human mind systematically associates primary
emotions to a range of encountered stimuli. At physiological level, secondary
emotions need both the support of the limbic system and the participation of
prefrontal cortices.
(3) The third category is background feelings generated by the body states that
prevail between emotional states. Thus, background feelings are of low intensity.
The collection of such feelings persisting over a longer period of time is dened
as mood.
It is important to notice that emotions are not simple mental processes, but complex
and varied collections of responses, which imply a whole range of mental and physical
transformation process (for further considerations, follow works by, e.g. Oatley and
Jenkins (1996) and Lowenstein and Lerner (2003)).
For the long period of time, economic research paid no attention to emotions in the
process of decision making, because emotions are responsible for destroying rational
economic behavior of the economic agents and having negative impact on the theoretical
models (for further considerations follow works by, e.g. Smith (1759) and Peters and
Slovic (2000)). On the other hand, Kahneman and Tversky (1979) put a cornerstone of
behavioral nance and account the original heuristics-and-biases for the failures coming
from the use of simple decision rules, called heuristics, on the decision rationality.
The analyzed heuristics were mainly cognitive, and emotions were considered to enlarge
the panoply of causes for failure of behavior patterns. However, psychologists and
neurobiologists were the rst to recognize the fact that emotions (willingly or
unwillingly) always impact human decisions. Recent studies on this subject show that
emotions can have both positive and negative effects on the decision-making process.
Damasio (1996) and Frijda et al. (2000) claim that negative effects could occur in the
case when emotions have no actual object and can be misattributed to false causes,
causing biases against some objective facts or interfering in memory. On the other hand,
it is to be noticed that also positive effect is possible and recently published papers are
covering this idea: Damasio (1996) proposes that emotions turn into suitable decision
tools when the quality of decisions is measured by the survival in a given environment.
Elster (2003) claims that emotions improve decision making in respect to avoiding the
delay of decisions as they help to come to some decision and to improving the decision
quality (even though it could be achieved exclusively by rational consideration).
An interesting idea was provided by Lo (2004) developing adaptive markets hypothesis
that makes an attempt of settlement market efciency with behavioral evidence that has
been originally interpreted as a counterexample of rationality. The hypothesis builds on
a principle stressing that individuals (also economic agents) act in self-interest, make
mistakes, learn and adapt to changes. Their behavior is not necessarily intrinsic and
exogenous, but it depends on the particular situation within the environment in which
the selection occurs. Individuals attempt to maximize the survival of their genetic
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297
material (in nancial market survival means gaining maximumprot), and the survival
is based on past experience and best guesses about possible outcome. It is possible to
conclude that decision rules in nancial markets consist of heuristics offering best
adaptation to the current state of environment.
Investors categories
In the previous part, it was shown that emotions play signicant role in the process of
decisions making, and the main purpose of the next two parts to nd how emotions
become evident in real settings in the nancial markets. In order to do so, it is
important to dene investors categories trading on the nancial market one and the
same risky asset. For these purposes, several studies are used: Lo and Repin (2002)
claiming that emotions are signicant determinants of the evolutionary tness of
nancial investors, even though the more experienced market participants exhibit
weaker emotional reactions, it is clear that emotions always become evident. These
results were gained based on the study with ten professional traders during their
trading activity, while using real time data and dening different types of events
(deviations from the mean, trend reversals, volatility events, etc.). Lo et al. (2002)
worked on another study and nd that extreme emotional responses are unproductive
for the trading performance. Shiv et al. (2005) argue that emotionally impaired
economic agents are more willing to gamble for high stakes than non-impaired ones, as
they do not experience the unpleasant feeling of loss.
Considering the discussion above traditionally used categories do not cover all the
possibilities and that is why there is a necessity to implement a new category
emotional investor (or trader). To sum up, in the current paper the three different
categories of investors are used: rational investor, noise investor, and nally emotional
investor. The fundamental for the further research is that the formation of beliefs is
based on how information is perceived. It is assumed that in this context, rational
investors consider both past and present available information and both sources of this
information are equally important for price valuation. This group of investors performs
in the Bayesian spirit (using a balance of combined elements) and is aver of the existence
of other market participants with specic beliefs and possible inuence on prices.
Emotional investors remain unconcerned with the existence of other market players and
tend to under- or overweight the information. Based on this statement, it can be assumed
that this category act either impulsively or conservatively, because it is guided by
their personality traits. Such behavior is a good example of frequent thinking heuristics.
And nally, noise investors are assumed to act randomly (their behavior is less relevant
for the current paper and is not going to be described further). According to the economic
literature, rational investors are willing to maximize the expected utility of wealth,
however, this category does not necessarily accumulate the highest wealth in the
market. Emotional investors simply follow their intuition and act in accordance with
their subjective beliefs about prices; that is why the emotional strategy can be seen as an
example of action heuristics.
Mathematical model as practical implication of the theoretical
considerations
In the previous part of the paper, the necessity for the introduction of new investors
category emotional investors (traders) was discussed. The study object of this
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section is to build a mathematical model in order to show how subjective beliefs of
different economic agents could be translated into prices of risky assets on the nancial
market. It is to be noticed that these subjective opinions are specic for each group of
economic agents and inuence their decisions and actions in particular way. Assuming
that price development of any asset traded on the nancial market depends on the total
order ow (received by the market maker) it is possible to formulate a demand strategy
for each group of investors, and show how prices result from these demands. As a
result the model is going to be established explaining the inuence of beliefs (and that
is why also emotions) of different market participants on their behavior (demand
strategy; price settlement, etc.) on the market.
The model is based on the following assumptions:
.
There are three homogenous groups of investors on the market: rational investors
(referred by the superscripts rational), which followthe basic principles of rational
behavior; emotional investors (referred by the superscripts emotional), which
follow their intuition and nally noise investors (referred by the superscripts
noise), which do not follow any particular strategy (their opinions play no
particular role with respect to the price evolution, that is why these categories of
investors are going to be only briey mentioned in the current model).
.
Time is discrete and trades (single risky asset) t are submitted simultaneously
by each market participant and are executed by risk neutral, independent, and
competitive market maker.
Main idea at the current point is to discuss how investors pick out the information,
evaluate it and integrate in their strategies. As it was already mentioned, the author is
going to concentrate mainly on the rational and emotional investors (paying less
attention to the noise investors, since they act randomly). Beliefs about past, current, and
future situation development on the nancial market of each rational and emotional
investor could be associated with a probability density function (f ) that depends on the
public information set (F
t21
) and describes how each group of investors perceives the
distribution of the current returns. The price of any risky asset on the nancial market is
a random variable and for the rational investor it could be dened as following:
P
rational
t
P
t21
exp r
rational
t
_ _
1
where P is a price at particular time and r is a random variable corresponding to the
emotional subjective log-return of an asset. For the emotional trader, the notion would be
the following:
P
emotional
t
P
t21
exp r
emotional
t
_ _
2
Owing to the fact that beliefs of the different investors groups originates based on
the different perception and interpretation of the same public information available
(no insider trading is allowed), this could lead to the discrepancy in prices. Investors
opinions are based on beliefs about past and current information and this particular fact
is to be regarded in the model. Evaluation of the past information leads to the a priori
views in respect to present returns and are specic to the every group of investors.
Rational investors are characterized by considering the existence and acting of other
market participants and are formulating ideas (guesses) about beliefs and opinions
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299
of other economic agents, while the emotional investors are following exclusively own
intuitions. R
i
is dened as the set of a priori opinions that are considered by a group of
investors i to be relevant for the evolution of current prices on the nancial market and
w
i
stands for an estimation of the joint probability density function of the relevant a
priori opinions over the group specic set of information:
R
i
t
, r
rational;past
t
; r
emotional;past
t
; r
noise;past
t
_ _
3
Current beliefs of the investors stand for the opinions of each group rational or
emotional investors concerning the possible development of present prices according
to a priori opinions. The following function explains howthe investor group i values the
importance of the relevant a priori opinions in R
i
and their inuence on current
log-returns:
g
i
r; R
i
t
4
Subjective probability densities, describing specic beliefs are obtained by integrating
the current beliefs over the set of relevant a priori opinions. The introduced measure is
the probability density function of the a priori formulated beliefs for group of investors i:
f
i
r
_
R
k
i
q
i
yg
i
r; ydy 5
where k
i
is the number of a priori opinions that are relevant for the group i and y is a
relevant a priori opinion. The model describes the traditional Bayesian way of decision
makingfollowedby a rational investor. In order to be complaint with requirements of the
emotional investor (decisions are made based on the intuition, and there is a clear
tendency to over- or under-valuation in respect to importance of the past and present
information) the putting of distinct belief weights a and b (a;b . 0) is necessary
(for further considerations follow the work by Shefrin (2005)). In accordance to this
necessity, it is possible to modify equation (5) as following:
f
i
r K
i
ab
_
R
k
i
q
i
y
a
g
i
r; y
b
dy 6
where parameter Kensures that the function keeps being a probability density function:
K
i
ab

_
R
k
i
*R
q
i
y
a
g
i
r; y
b
dydr
_ _
21
7
It is necessary to underline that rational investors are capable to combine past and
present information in the balanced way, so that parameters could be set as a b 1,
while for the emotional investor it is necessary to estimate b . a in case if emotional
reaction on the present information in the market prevails and b , a if the past
information plays a crucial role according to the investors belief.
It was already mentioned that there could be possible discrepancies in respect to the
belief formation by different groups. Based on this fact, it should be noticed that also
different distributions of subjective beliefs are also possible. For reasons of theoretical
simplicity, the model uses parameterized normal distributions.
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As far as market participants have formed beliefs in regard to the price of a risky
asset, they are ready to come up with a decision about the trading amount of this asset.
In order to clarify this question, the mechanism of price settlement is to be discussed.
It was already mentioned that prices are set by a risk neutral market maker, xing the
current price of an asset proportionally with current total order ow Q
t
:
P
t
P
t21
lQ
t
8
where l . 0 and is a reversed measure of the market depth. The market depth gives
the order size necessary in order to move the market by a given amount (for further
details, follow discussion by Hasbrouck (2007)). The total order ow Q
t
stands for the
sum of all buy and sell orders issued by the three trader groups (emotional, rational,
and noise investors) and could be dened as following:
Q
t
N
rational
Q
rational
t
N
emotional
Q
emotional
t
N
neutral
Q
neutral
t
9
Based on the previous considerations, it is possible to construct a model in order
to answer the questions how investors detect the strategy (long or short) and the
dimension (amount of the assets) of the order. Above, it was already stated that
rational investors act in accordance with traditional principles of wealth maximization,
that is why their decisions are dominated by reasoning. In contrast to this group,
emotional traders formulate their strategy based on intuition and decisions are driven
by affect (while noise traders act randomly).
Main purpose of rational market participants is maximization of expected wealth,
while being risk neutral. While it is assumed that any risky asset has a liquidation value
V$ 0(it is the true value of an asset). The expected wealth for the rational investor Wis
a result of streams of trades done and the demand strategy for this particular group
under condition of positive inverse market depth could be formulated as follows:
max W
t
W
rational
t21

V
2lN
rational
2
N
emotional
Q
emotional
t
N
noise
Q
noise
t
2N
rational
_ _
*
V 2l N
rational
*
V
2lN
rational
2
N
emotional
Q
emotional
t
N
noise
Q
noise
t
2N
rational
_ _ _ _
N
emotional
Q
emotional
t
N
noise
Q
noise
t
__
10
Rational investors are trying to maximize their wealth, taking decisions based on the
information available, and considering ideas and actions of other market players like
emotional and noise investors. Following this idea, a demand strategy of rational
investor could be expressed as:
Q
rational
t
b b
rational
R
rational
t
21
_ _
P
t21
11
where b stands for sensitivity of the demand to price expectations. It was already
underlined that emotional investors follow their intuition in the process of establishing
the demand strategy, paying no attention to different strategies of different market
players and to wealth maximization, as they are using heuristics:
Q
emotional
t
b
emotional
R
emotional
t
21
_ _
P
t21
12
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decision making
301
Previous considerations are leading to the conclusion that when rational investors are
acting in accordance with expected wealth maximization approach, the total order ow
results could be expressed as follows in equation (13), while returns in equilibrium
results as a sum of subjective returns (equation (14)):
Q
t

V
2l

N
emotional
Q
emotional
t
N
noise
Q
noise
2
13
r
t
<
V
2P
t21

l
2
N
emotional
b
emotional
r
emotional
t
N
noise
r
noise
t
_ _
14
It is necessary to consider that both emotional and noise investors (even though they
were less considered in the current paper) play an important role in price settlement
mechanism, and their inuence on the market is directly proportional their presence on
the nancial market. On the other hand, the power of this both groups is restricted by the
liquidityavailable onthe market. Basedonthe theoretical considerations, it is possible to
conclude that including new group of investors emotional market player allows to
analyze the inuence of emotions on the decisions-making process and make an
estimation that the more emotional investors on the market (the higher N
emotional
) the
higher returns and volatility on the market is possible (could be explained with equal
probability of default and gains). The same remark is possible to make in respect to
higher emotional demand sensitivities b
emotional
. And nally, the more unbalanced
information is used to choose investment strategy (the higher the weights a and b) the
lower market volatility.
The following section is going to analyze by means of simulation techniques and for
various parameter constellations, the evolution of market returns and of the rational
and emotional wealth that results from the theoretical setting developed in the
mathematical model. Please note that the below-presented results are preliminary
conclusions and could vary under other assumptions made. In order to keep the
exposition as clear as possible, only the most important results are going to be
presented. The subsequent ndings map average values obtained over n 10 rounds
of each T 100 trade times. Testing population consists of n 100 traders, out of
which the number of noise traders is xed to ve, while that number of rational and
emotional traders can vary. In accordance with Hasbrouck (2007), the inverse market
liquidity is xed to 0.08. The scenario used assumes the low proportion of emotional
traders 25 percent on the nancial market. The rst step is generating the normally
distributed noise terms with the considered standard deviations. Use of the above
parameters allows deriving the emotional subjective returns both in logarithmic form
returns and as gross returns. After computing the current subjective returns, the
demand of each trader group as well as corresponding wealth is calculated. Based on
the theoretical model and data simulations, the following conclusions are relevant: as it
was observed in the theoretical part, the market volatility should be lower when the
asymmetry in the emotional way of combining past and current elements of belief is
more pronounced. This particular case is shown in Figures 1-3. Log-returns become
more volatile for lower ratios b a, when emotional traders form beliefs
conservatively. In very general terms, it could be concluded that markets where an
emotionally guided activity induces specic conditions to which rational traders adapt,
appear to be stable in front of non-recurring shocks but rather inefcient, in the sense
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302
that prices are predictable to a certain degree. A conservative belief formation on the
part of the emotional traders may reduce the inertia of price movements and hence the
predictability. The demands of individuals belonging to each trader group are shown
in Figures 4-6. The emotional demand is on average positive, pointing out the fact that
emotional traders mostly prefer to buy the risky asset. This demand becomes more
volatile and follows a more pronounced up-sloping path for lower b a ratios. Note
that the individual activity of rational traders remains low in all cases compared to that
of the emotional or noise trading individuals. Indeed, the rational group has to face an
increased total order ow issued by the other traders, but it is at the same time
sufciently numerous for the individual participation of each rational individual to
remain at low levels (Figures 4-6).
Figure 1.
Log-returns of emotional
traders with belief
weight ratio 100
0
0.2
0.1
0
0.1
0.2
0.3
0.4
r
0.5
10 20 30 40 50 60
t
70 80 90
Figure 2.
Log-returns of emotional
traders with belief
weight ratio 1
0
0.2
0.1
0
0.1
0.2
0.3
0.4
r
0.5
10 20 30 40 50 60
t
70 80 90
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Conclusions
Current paper tended to describe the role of emotions in the process of nancial
decision making and dene theoretical model for three particular economic agents
categories: rational, emotional, and noise investors. As all of these categories use
different methods in order to evaluate information available and based on this analysis
to come to the subjective opinion, and to choose in their view appropriate trading
strategy. Rational investors have a tendency to combine past and present information
in a traditional Bayesian manner that is why their strategy has a goal to maximize
expected utility of wealth available. Emotional traders form beliefs in an unbalanced
Figure 3.
Log-returns of emotional
traders with belief weight
ratio 0.01
0
0.2
0.1
0
0.1
0.2
0.3
0.4
r
0.5
10 20 30 40 50 60
t
70 80 90
Figure 4.
Individual demand of
emotional traders with
belief weight ratio 100
0
12
10
2
4
6
8
0
2
4
Q
r
,
Q
e
,
Q
n
6
Emotional traders
Noise traders
Rational traders
10 20 30 40 50 60
t
70 80 90
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304
manner, while putting different weights on diverse information sources, because they
are prone to thinking heuristics commonly met in practice, and they are not concerned
with the existence of other economic agents present on the market. Emotional investors
blindly follow their beliefs and hence make use of heuristics. Noise traders act
randomly. The testing model shows that emotional traders can make money from their
trades in markets similar to those modeled. Moreover, in the short run, they can even
come best off in terms of wealth, as well as with respect to the growth of individual
Figure 5.
Individual demand of
emotional traders with
belief weight ratio 1
0
20
15
10
5
0
5
Q
r
,
Q
e
,
Q
n
10
10 20 30 40 50 60
t
70 80 90
Emotional traders
Noise traders
Rational traders
Figure 6.
Individual demand of
emotional traders with
belief weight ratio 0.01
Emotional traders
Noise traders
Rational traders
0
5,000
4,000
3,000
2,000
1,000
2,000
1,000
0
3,000
Q
r
,
Q
e
,
Q
n
4,000
10 20 30 40 50 60
t
70 80 90
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wealth. In the long run, their chances of survival, measured by the growth of individual
wealth, become yet comparable to those of their rational peers.
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About the author
Jekaterina Kuzmina is a doctoral student at BA School of Business and Finance, Riga, Latvia.
She obtained a Master of Science in Finance and Investment Banking from Frankfurt
School of Finance and Management, Frankfurt am Main, Germany and a Master of Arts in
Philology from University of Latvia, Riga, Latvia. Jekaterina Kuzmina can be contacted at:
jekaterina_kuzmina@yahoo.de
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