Are investors willing to pay more for a stock when the sun is shining, than when it is raining? "Yes", is the surprising answer to emerge from recent research. Our mood swings, from happiness in the sun to depression in the rain, rule our behaviour.
When we are happy we view everything more optimistically and this sunshine-induced optimism leads us to view the prospects for stocks more favourably and, consequently, means we are willing to pay a higher price for stocks.
This finding is not just one of those quirky anecdotes to relay to the guests at your next dinner party. It is potentially a finding that rewrites the rulebooks on how stocks are priced. It tells us that we have to change the way we view the stock market. We have to move from viewing the stock market as simply a collection of numbers to viewing it as a collection of people.We need to study psychological theories to understand the manner in which people are unpredictable. We need to know how people actually make decisions, such as stock investment decisions. One set of psychological theories, dealing with emotions, argues that people's decisions are heavily influenced by how they are feeling at the time of making a decision.
The weather affects how people feel. People are happy in the sun, depressed in the rain, and get angry and frustrated in conditions of high humidity and extreme heat. Behaviour is also affected. On bright days people are more likely to give money to beggars, tip waiters and waitresses, and generally be helpful to other people. If the weather affects people's feelings and behaviour in their everyday activities, why should we not expect it to affect their investment behaviour? Why shouldn't people in good moods be willing to pay more for stocks than people in bad moods?
There is strong theoretical support for this being the case. A leading US academic, George Loewenstein at Carnegie Mellon University in Pittsburgh, argues that feelings have the greatest effect on decision-making when the decision involves risk and uncertainty, such as the decision to invest in stocks. David Hirshleifer at Ohio State University argues that it doesn't matter that the mood swings might be driven by something as simple as the weather. In fact, the weather is a particularly suitable means of measuring feelings, as everyone in the same locality is affected by the same weather.
We obtained the daily prices for the ISEQ index from January 1988 to December 2000. Met Eireann provided us with the historical daily cloud cover, rain, humidity and temperature information for Dublin for the same time period. We calculated the hours of sunlight in the day using a formula given in a previous study in this area.
Now that we had the weather and the stock price data, we proceeded to compare the daily fluctuations in the weather to movements in the ISEQ index. Our findings confirmed what the theory suggested. The weather seems to have affected Irish stock returns. Of most significance was the rain, followed by the seasonal variation in the hours of sunlight in the day. To put the strongest finding in simple terms; the returns on Irish stocks have been reliably lower than average on days when it has been raining.
This research strikes at the very heart of existing stock market theory. Traditional attempts to understand the movement and pricing of stock prices have heretofore totally ignored the role of psychology.
Traditional stock market researchers believe that the rational and informed investors in the will cancel out any mispricing effects of irrational decision-making by some investors. Thus, stock prices will, in aggregate, be efficient.
This is ivory tower thinking at its detached best. People do not suddenly become hyper-rational when they invest in the stock market. They are still people, and people have failings that prevent them making perfect decisions.
It is highly likely that the stock market will collectively reflect some of these faults. The finding that the weather affects investor's feelings and in turn affects stock prices is but one illustration of how psychology can help to increase our understanding of how stocks are priced.
Michael Dowling is a researcher at the Trinity School of Business Studies.
