Dux Nest

Investing in the weather is a lot more common than you may think. In fact some investments a based entirely on the weather, such as weather derivatives. This article however discusses the impact of our feelings on our decisions in an area of study known as behavioural finance.

Behavioural finance focuses on decision-making under uncertainty, and demonstrates that human decisions systematically depart from those predicted by the rational decision-making assumption of traditional economics. (Tony Naughton.  (2002). The winner is…behavioural finance? Journal of Financial Services Marketing, 7(2), 110-111.)

So how much does a sunny day impact on our behaviour?

Will the market rise just because the weather is nice?

Does Seasonal Affective Disorder (SAD) really have an impact on investor behaviour? If so, could you make money by simply investing in the theory that market to rise from winter to summer?

A good deal of recent research is concerned with costly irrational financial behavior. Investor overconfidence, myopia, the irrational hesitancy to realize losses, or other unusual behaviors may affect the outcomes of financial decisions. It is further possible that these irrationalities are not sufficiently predictable by more rational traders, so that the behaviors do not lead to arbitrage opportunities that would keep market prices efficient. The inability to arbitrage away irrational outcomes would obviously be a major concern for financial markets.

While the research is concerned mostly with the interrelationship between trade outcomes and price movement, increasing attention is being paid to the relation between physiological phenomena, such as the weather, and their effect on stock market returns. The underlying premise of this parallel line of investigation is that in the short run stock returns may be related to predictable changes in an investor’s psychological status, and that this investor’s psychological status may be predictable by observing exogenous variables such as the weather.

In other words, this physiological evidence comes in addition to the growing evidence of unexplained retail investor irrationality. Hirshleifer and Shumway find that if transaction costs are sufficiently low, a relatively clear morning can lead to profitable afternoon stock trading.

Research has also investigated various other exogenous factors that may drive investor behavior. These factors include an unusual cast of characters, such as the lunar cycle, the switch to daylight-savings time, seasonal affective disorder (SAD), and even geomagnetic storms.

These findings are being taken a lot more seriously than other work that relates stock returns to such factors as whether the National Football Conference team wins the Super Bowl. (Piman Limpaphayom,  Peter R Locke,  Pattarake Sarajoti. (2005). BUTTON UP YOUR OVERCOAT! TRADING AGAINST THE WIND. Corporate Finance Review, 10(3), 12-18.) Findings support the theory that floor traders exhibit trading behavior that appears related to their local weather. For example, traders, who are often modeled as market makers, are more likely to buy on relatively calm days, suggesting a weather induced bias in their quoting behavior: quotes decline on poor weather days.

In addition, the effective bid-ask spread is smaller on calmer days, also suggesting improved attention on calm days. More importantly, weather may influence the bottom line for futures floor traders.  Results show that daily floor trader income varies with both cloud cover and wind strength. (Piman Limpaphayom,  Peter R Locke,  Pattarake Sarajoti. (2005). BUTTON UP YOUR OVERCOAT! TRADING AGAINST THE WIND. Corporate Finance Review, 10(3), 12-18.)

The findings extend the literature showing that financial decision makers are affected in a very real way by weather. Obviously, with sunshine, geomagnetism, and wind showing effects on securities prices, studies find exogenous factors affecting trader behavior. Additional external factors may cause seemingly irrational shifts in investors’ mood and hence affect securities price movements. Some effects (e.g., lunar, solar, geomagnetic) are global, these may affect the global price of risk. However, if some effects are local and only affect some traders, then any temporary or localized effect need not be troubling. Nonetheless, traders may wish to be informed as to their potential for weather-induced biases. (Piman Limpaphayom,  Peter R Locke,  Pattarake Sarajoti. (2005). BUTTON UP YOUR OVERCOAT! TRADING AGAINST THE WIND. Corporate Finance Review, 10(3), 12-18.)

The middle truth is that there is a constant interplay between the fundamentals of an investment and the psychology of the investors who own it. Sometimes the psychological effects will take over (the herding that led to the tech bubble), but then the fundamentals periodically reassert themselves (the bust). (Jeff Sanford.  (2004, May). Think you’re a smart investor? Canadian Business, 77(11), 75. )

In determining investor behaviour it is important to consider… is the sun shining where it matters? Taking a tip from the real estate agents… location location location.

Tags: Behaviour, Behavioural Finance, Economics, Investment, Uncertainty, Weather.