Mood, Memory, and the Evaluation of Asset Prices

Abstract I model the effect of associative memory on asset prices. The model includes mood-congruent memory, which predicts that the subjective goodness (or badness) of the agent’s affective state (e.g., mood) is a cue for positive (negative) information stored in long-term memory. I also include rehearsal, which implies that data recalled in the recent past are more likely to be recalled in the present. I show that mood-congruent memory causes the set of recalled information to be biased, and rehearsal generates autocorrelation in the biases across periods. The theory provides novel explanations for short-run continued overreaction to news, long-run correction of these effects, and excess volatility. I also make the novel predictions that excess volatility is highest during downturns, price biases are increasing in fundamental volatility, knowledge/experience may intensify these biases, and asset prices exhibit excess comovement.