How Emotions Drive Stock Returns

If I were asked to list the major intellectual breakthroughs of the last half century, I would certainly include the revolution in our understanding of emotions. … Emotions and reason are one system integral to good decision-making. You’re Only as Smart as Your Emotions, David Brooks

While financial markets have long been viewed through the lens of rational decision-making, the field of behavioral finance has gained an increasing amount of attention in academia over the past 15 years or so as pricing anomalies have been discovered. Pricing anomalies present a problem for those that believe in the efficient markets hypothesis.

Shehub Bin Hasan, Alok Kumar, and Richard Taffler, authors of the May 2025 study "Investor Emotions and Asset Prices,” published in the Third Quarter 2025 issue of the Financial Analysts Journal, contribute to the behavioral finance literature by examining by examining how emotions—not just sentiment—can drive asset prices. They distinguished their work from previous sentiment-based studies by focusing specifically on emotions rather than broader market mood indicators (such as the Baker and Wurgler Sentiment Index). This distinction is crucial because emotions represent more immediate, visceral reactions that can create temporary mispricings in the market.

What the Researchers Examined

They conjectured: “The experience of investing in a firm can generate emotional utility beyond the utility of wealth, as investors are likely to enter emotional relationships with stocks, and this will alter their perceptions of risk and return associated with their investments.”

The study's methodology centers around developing what the authors call a "market-level emotion indicator" which captures the aggregate emotional state of the market by analyzing various data sources that reflect investor emotions in real-time. They employed a standard bag-of-words technique using a keyword dictionary made up of 295 salient context-relevant emotion words to construct our market-level emotion index (MEI). Their data base covered 65,825 articles collected from 21 national and local level newspapers (with the four widely circulated national-level U.S. newspapers—The New York Times, The Washington Post, Wall Street Journal, and USA Today—accounting for about half the articles). For each month from January 1990 to September 2022, they measured MEI using the total counts of their emotion words in newspaper articles to the total number of words in that month.

Using this market-wide emotion measure, the researchers then calculated individual stocks' sensitivity to emotional shifts—termed "emotion beta." Just as traditional beta measures a stock's sensitivity to market movements, emotion beta quantifies how much a stock's price responds to changes in market-wide emotional states. They estimated individual firm-level stock emotion betas using 60-month rolling regressions of excess stock returns on the market emotion index and other asset pricing factors.

The research team analyzed this relationship across the broad cross-section of U.S. stocks to understand how emotional sensitivity translates into return patterns and investment opportunities.

Key Findings: The Emotion Premium

They found that stocks with close to zero emotion betas did not covary with the market emotion index. The study's most striking finding was the existence of what could be called an "emotion premium" in stock returns. Stocks with high emotion betas—those most sensitive to market emotional shifts—consistently outperformed stocks with low emotion betas. The performance differential was both statistically and economically meaningful.

They sorted stocks into decile portfolios based on emotion beta in the previous month and measured the monthly returns of the resulting portfolios. They found:

· During the January 1995 to September 2022 period, the high-minus-low portfolio earns value-weighted abnormal returns ranging from 0.53% to 0.75% per month (t-statistics = 3.25 to 4.24, respectively) on a risk-adjusted basis.

· Alpha estimates were higher when arbitrage costs were high.

· The impact of investor emotion on asset prices was robust—investor emotions influence prices during good and bad economic and market conditions, and also during low and high investor sentiment periods. However, when market-wide mispricing was more (less) pronounced, the emotion beta-based trading strategy generated even higher (lower) alphas.

· The emotion beta-based trading strategy generated qualitatively similar alphas even when adjusted for risk using factor models—it’s a unique anomaly separate from sentiment.

· Emotional mispricing didn’t persist indefinitely—the performance differential corrected itself within approximately six months, suggesting that while emotions create temporary inefficiencies, market forces eventually restore rational pricing.

· Industries such as pharmaceutical, electronic equipment, computers, retail, and business services had high-emotion betas.

· The hedge portfolio generated a significant alpha when they considered only the S&P 500 firms, the largest 1000 stocks, or the 1000 most liquid stocks.

· In tests of robustness, they found results and significant alphas during bullish and bearish market states, low and high volatility periods, crisis and non-crisis subperiods, and sub-periods of high and low investor sentiment.

Understanding the Mechanism

The research provides insight into why emotions create these return patterns. Unlike traditional sentiment indicators that might reflect longer-term optimism or pessimism, emotions represent more immediate, intense reactions to market events. These emotional responses can cause investors to overreact to information, creating temporary mispricings.

High-emotion beta stocks appear to be those that investors view through a more emotional lens—perhaps because they're associated with exciting growth stories, represent familiar consumer brands, or operate in sectors that generate strong emotional responses. When market emotions spike, these stocks experience disproportionate price movements that often reverse as emotions cool and rational analysis reasserts itself.

Their findings led Bin Hasan, Kumar, and Taffler to conclude: “Overall, our results establish an empirical link between emotions and market mispricing.” They added: “In future work, it will be interesting to examine how emotions influence different types of market participants. For example, retail and institutional investors may overweight emotion-sensitive firms differently, which may have predictable implications for asset prices.”

Investor Takeaways

1. Emotions Create Systematic Mispricings

The research provides evidence that emotional reactions create systematic mispricings.

2. Timing Matters

The emotional mispricing effect appears to have a relatively short lifespan—correcting within about six months.

3. Emotions Are Distinct from Sentiment

Traditional sentiment indicators, while useful, don't capture the full picture of investor psychology. Emotions represent a separate dimension that can provide additional insights into market behavior and pricing inefficiencies.

Summary

Bin Hasan, Komar, and Taffler demonstrated that investor emotions create measurable patterns in stock prices. They developed an innovative "emotion beta" metric that identifies which stocks are most sensitive to market-wide emotional shifts. Their findings show that high-emotion beta stocks consistently outperformed low-emotion beta stocks, with a trading strategy based on this insight generating over 6% annual alpha. This emotional mispricing corrects itself within approximately six months, offering a distinct advantage separate from traditional sentiment indicators.

Looking Forward

This research opens new avenues for understanding market behavior and represents a significant advance in behavioral finance. By distinguishing emotions from broader sentiment measures, the authors have identified a previously unexplored source of return predictability.

For the investment community, these findings suggest that markets remain far from perfectly efficient. However, as with all market anomalies, the sustainability of emotion-based strategies remains an open question. As more investors become aware of these patterns and attempt to exploit them, the opportunities may diminish over time.

For most investors, the key insight may not be to immediately implement complex emotion-based trading strategies, but rather to recognize how their own emotions might be affecting their investment decisions—and to develop strategies for maintaining rational decision-making even in emotionally charged market environments.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.