Narrative Economics, Investor Behavior, and Asset Pricing

This thesis investigates the complex role of investor beliefs in asset pricing, uniquely leveraging the power of economic narratives that both shape and reflect these beliefs, particularly under extreme market conditions. By approaching investor beliefs as a “black box,” it shows that decoding narrative data provides an effective lens into the formation and evolution of these beliefs. Drawing on methods from natural language processing (NLP) and econometrics, the research examines four interconnected topics: the impact of “viral” narratives on the stock market, the capacity of narratives for predicting asset bubbles, the presence and impact of run-like behavior in corporate bond mutual funds, and the potential of narrative information to improve asset pricing models. The findings underscore the deep interconnection between investor beliefs and market outcomes, demonstrating how narratives reinforce sentiment and amplify fluctuations. Narratives can become viral due to both exogenous and endogenous reasons, and they rein- forces investor sentiment and intensifying market fluctuations. For instance, pandemic-related risk narratives persist well beyond their initial triggers, while opportunity narratives appear to amplify redemption risks in corporate bond funds. Furthermore, narrative-driven indicators demonstrate robust forecasting power in identifying bubbles and crashes, providing a leading signal that complements traditional financial and economics measures. When integrated into asset pricing models, information summarized from market narratives increases the estimates of attainable Sharpe ratio, indicating substantial predictive content that was under utilized in asset pricing. By illuminating how stories and collective interpretations shape investor beliefs and motivate investor behaviors, particularly under conditions of heightened uncertainty, this thesis bridges conventional finance theories with behavioral perspectives. It highlights the practical value of narrative-centric approaches for market participants, economists, and policymakers aiming to better anticipate and manage systemic risks. Through this work, narratives emerge as an essential component of modern asset pricing analysis, underscoring the importance of merging qualitative insights and quantitative tools to capture the intricate “ocean currents” that steer the giant vessel of financial markets.