Measuring the Behavioral Component of Financial Fluctuations: An Analysis Based on the S&P 500

We study the evolution of the behavioral component of the financial market by estimating a Bayesian mixture model in which two types of investors coexist: one rational, with standard subjective expected utility theory (SEUT) preferences, and one behavioral, endowed with an S-shaped utility function. We perform our analysis by using monthly data on the constituents of the S&P 500 index from January 1962 to April 2012. We assume that agents take investment decisions by ranking the alternative assets according to their performance measures. A tuning parameter blending the rational and the behavioral choices can be estimated by using a criterion function. The estimated parameter can be interpreted as an endogenous market sentiment index. This is confirmed by a number of checks controlling for the correlation of our endogenous index with measures of (implied) financial volatility, market sentiments and financial stress. Our results confirm the existence of a significant behavioral component that reaches its peaks during periods of recession. Moreover, after controlling for a number of covariates, we observe a significant correlation between the estimated behavioral component and the S&P 500 return index.