Affect in a Behavioral Asset-Pricing Model

Stocks, like houses, cars, watches, and other products, exude “affect”—that is, they are considered good or bad, beautiful or ugly; they are admired or disliked. Affect plays an overt role in the pricing of houses, cars, and watches, but according to standard financial theory, it plays no role in the pricing of financial assets. This article outlines a behavioral asset-pricing model in which expected returns are high not only when objective risk is high but also when subjective risk is high. High subjective risk comes with negative affect. Investors prefer stocks with positive affect, which boosts the prices of such stocks and depresses their returns.Stocks, like houses, cars, watches, and other products, exude “affect.” Affect is the feeling of good or bad, beautiful or ugly, admired or disliked, and it occurs rapidly and automatically, often without consciousness. Affect plays a role in the pricing models of houses, cars, and watches but, according to standard financial theory, plays no role in the pricing of financial assets.In this article, we outline a behavioral asset-pricing model in which expected returns are high when objective risk is high and also when subjective risk is high. High subjective risk comes with negative affect. Investors prefer stocks with positive affect, and their preference boosts the prices of such stocks and depresses their subsequent returns.The preferences of investors were gathered from surveys conducted by Fortune magazine in 1983–2006 and in additional surveys we conducted in 2007. From the Fortune data, we found that the returns of admired stocks, those highly rated by the Fortune respondents, were lower than the returns of spurned stocks, those rated low. This finding is consistent with the hypothesis that stocks with negative affect have high subjective risk and their extra returns compensate for that risk. We also found that admired companies have higher market capitalizations but lower book-to-market ratios than spurned companies. This finding is consistent with the hypothesis that size and book value to market value are proxies for affect.We gathered supporting evidence from our own surveys. In these surveys, we presented investors with only the names of companies and their industries and asked them to rate the affect of these companies. The questionnaire said, “Look at the name of the company and its industry and quickly rate the feeling associated with it on a scale ranging from bad to good. Don’t spend time thinking about the rating. Just go with your quick, intuitive feeling.” We found a positive correlation between these affect scores and the companies’ Fortune scores. Moreover, we found that positive affect creates a halo over stocks that results in perceptions that they promise high future returns coupled with low risk.