Sentiment or Habits: why not both?
European Financial Management Association 2021
32 Pages Posted: 19 Oct 2020 Last revised: 27 Oct 2022
Date Written: May 1, 2022
Habits and sentiment are important psychological behaviours in asset pricing.
This paper nests consumer sentiment as a risk factor into the Campbell and Cochrane
habit model and examine its impact on asset prices. The model provides an economic
mechanism for the pricing of sentiment risk through its impact on habit sensitivity
and equilibrium habit levels but finds its market price of risk much lower than fundamentals.
The sentiment factor subsumes risk aversion with a lower resulting risk
coefficient from a model without sentiment. The additional sentiment factor does not
improve the CC model with both models returning matched moments error of 12%
from 1980Q1 to 2021Q4. This includes the COVID period during which the risk premium
was driven more by consumption growth than sentiment.
Keywords: Asset Pricing, Behavioral Finance, Habit Utility Models, Market Sentiment, COVID pandemic
JEL Classification: G12, G17, G40, G41
Suggested Citation: Suggested Citation