When Love and Hate Collide: A Network Analysis of emotional contagion in Financial Markets

Abstract

Emotional finance introduces the notion that financial markets may be driven by the co-existence of fully-rational and emotional investors, driven by phantasy. The analysis of emotional finance is informed with reference to a Freudian psychoanalytical framework.

In this paper, we add to the existing information cascade and herding research by developing an emotional finance model that examines the effects of phantasy investors on the decisions of rational investors under dynamic pricing. We consider a financial market for a risky asset in which traders’ emotions develop over time based on how they perform. We hypothesize that emotions affect traders’ behavior in a number of ways, through love and hate, where love results in investors buying and holding their stock regardless of the realized profit or loss.

The assumptions of the model include a constant population size of investors, and that all individuals are identical in their susceptibility to various emotional states. We also assume that the probability of becoming in love with stock is independent of an individual's history of emotional episodes and mood. We introduced an elementary agent-based asset pricing model consisting of three trader types: fundamental traders, emotional traders, and semi-emotional traders. The model comprises two features: 1) an emotional herding mechanism based on the susceptible-infected susceptible (SIS) model, and 2) wealth price herding based on wealth preferential attachment. We did this by creating sets of investors with given attributes and behaviors. Then we considered a set of investor relationships and methods of interaction: an underlying topology of connectedness defining how and with whom agents interact. Then we considered the market network where investors interact with their environment, and with other investors.

Combining analytical and simulation methods, the interaction between these elements is studied in a four-phase plane of the price movement: 1) prices resembling a bull market; 2) prices resembling a bear market; 3) U-shaped pricing trends; and 4) n shaped pricing trends. Finally, we compare our approach with a traditional information cascade/herding model incorporating phantasy investors.

We have formally demonstrated that emotions can be thought of as infectious diseases spreading across social networks. We have introduced a novel form of mathematical infectious disease model for describing the spread of emotions. We have validated this model by studying emotional propagation between different group of investors across a social network.

Keywords: Emotional Finance; Investor Networks; Herding; Emotional Contagion; Phantasy; Freudian Love and Hate

JEL Classification: G02, G11