Sentimental Habits

Habits and sentiment are key psychological behaviors in asset pricing. This paper studies the interactive impacts of sentiment and habits on asset pricing using the Campbell and Cochrane 1999 habit model as a framework model. A positive sentiment shock emanating from firms is modeled in the drift of the consumption and the habits sensitivity. It has a lagged effect on inter-temporal consumption and increases the risk-free rate by an increased habit sensitivity and the precautionary savings motive. The increased habit sensitivity also increases the risk-taking activity of the agents. The model further offers a behavioral explanation of the value premium puzzle in the context of habit models due to relatively lower price-consumption ratios in a negative sentiment environment