In Search of Animal Spirits: Evidence from Idiosyncratic Volatility of Emotions

This study examines the effect of “animal spirits” risk, measured by the idiosyncratic volatility of emotions (EMO), on asset prices. Portfolio analysis shows that a trading strategy consisting of a long position in a High-EMO quintile and a short position in a Low-EMO quintile generates an annualized alpha of 5.30%. Multivariate analysis suggests that a one-standard-deviation increase in EMO is associated with a 3.25% increase in stock returns. We further show that, instead of being a mispricing factor, EMO captures the risk premium of stock returns, which indicates that EMO premia is a distinct phenomenon from the idiosyncratic volatility anomaly (Ang et al., 2006; 2009). Moreover, the pricing effect of EMO is less significant for stocks with high institutional ownership and more significant for stocks with high individual ownership, suggesting that the source of behavioral risk is from noise trading instead of informed trading.