Contrast Effects in Investment and Financing Decisions

Abstract

This study develops an experimental design to examine whether prior market information inducing an incidental positive or negative emotion (contrast effect) distorts the risk attitudes of individuals. We find that individuals exposed to a positive emotional stimulus amplify risk-seeking in the gain domain, that is framed in terms of investment decisions, as opposed to individuals exposed to a negative emotional stimulus. The deviating risk preferences support an interpretation that prospect theory’s subjective values of decision outcomes and decision weights in the gain domain are functions of emotions. However, individuals exposed to different contrast effects behave similarly in the loss domain, that is framed in terms of financing decisions, regardless of different emotional stimuli. We find that, on average, individuals spend 16% more time making financing decisions than investment decisions. The results provide robust evidence that contrast effects can lead to mistakes in investment decisions and suggest that financing decisions may require more mental effort than investment decisions. The extra time appears to erase contrast effects.

Keywords: Risk attitude, Emotion, Corporate Finance, Behavioral Finance, Investment

JEL Classification: D81, D91, G11, G30, G41