Over three decades of China’s breakneck economic growth, the environment has paid a heavy price. On a good day, Beijing’s air quality index (AQI) can be as low as 25 – on bad days it can climb to 500 or above, almost double the pollution level considered hazardous.

One study earlier this year found that more than 80 per cent of Chinese are regularly exposed to pollution levels deemed unhealthy by the US Environmental Protection Agency, with air pollution killing about 4,000 people a day or accounting for about 17 per cent of all deaths in China.

This surge of pollutants not only has a direct impact on health but its burden on the economy and business is becoming increasingly apparent. Last year for example Japanese electronics maker Panasonic became the first international company to pay a ‘pollution premium’ to its expatriate staff in China in an effort to persuade them to stay.

In addition to health issues, bad air quality has also been shown to affects people’s moods, making them more likely to feel unhappy, anxious, depressed and apathetic when air quality is low. Bad moods make people more pessimistic and research has shown that pessimism causes people to reduce the value they place on things.

So what impact does pollution have on Chinese investors and, as a result, on stock prices?

Several studies have examined the effect of weather and other environmental factors on trading behavior. The NYSE’s daily return for example has been shown to be associated with weather conditions in New York City – the cloudier the city is, the lower the stock exchange index.

Our study extended this stream of research by examining whether air pollution in China affects stock returns through its impact on investors’ mood.

Perceived pollution

ThinkAloud4We found that while the actual local air pollution has little direct influence on stock prices, what matters is how severe the perception is perceived to be.

More precisely, we found that when local air quality is perceived by investors to be worse relative to air quality in Beijing, there is a noticeable and significant negative impact on stock prices. Furthermore, this perception of relative air quality also negatively affects trading volume.

Out study examined daily pollution data from cities across China as well as stock market data from 2000 to 2013.

One reason may be that given Beijing’s high profile and notorious pollution, the daily AQI readings from the Chinese capital attract wide attention. As a result many investors use it as a natural reference point to define the relative air quality of the city they are in.

But why should the perception of relative air pollution bias stock prices?

Shaping perceptions

The psychological theory known as social comparison suggests that people form sentiments or moods when they compare their personal status with that of other people while evaluating their own status or welfare. This shapes their perceptions of value and, as a result, their behavior and decisions.

In the case of pollution levels investors may compare their local AQI – or perceived AQI – with that of Beijing’s and feel happier or sadder when their city is less or more polluted, in turn influencing their stock trading habits.

Interestingly, while AQI levels have little impact on stock prices, it influences stock prices negatively when people make comparisons between their city’s AQI and Beijing’s AQI. This means that when the local pollution is bad compared to Beijing’s, investors are less happy and stock prices are likely to go down.

China’s stock market is dominated by relatively unsophisticated individual investors, whose investment decisions are more likely to be affected by seemingly non-stock related matters.

Given that, we then looked to see whether this effect was less pronounced among institutional investors, since they are generally thought to be more sophisticated and hence, less affected by factors such as air pollution.

Trading decisions

Our results showed that institutional investors are also affected by their perception of relative air quality when making investment and trading decisions.

Another consideration was whether it was an economic slowdown caused by the impact of pollution on business operations rather than poor sentiment on the part of investors that brought stock prices down.

However our study found that the mood arising from perception of relative air quality affects stock prices well beyond that accounted for by economic fundamentals – hence sentiment caused by pollution plays a significant part in stock prices.

This perception of relative AQI also influences trading volume. People tend to trade less when the perceived local air quality is worse than Beijing’s, thus leading to a lower daily stock trading volume.

Similar to past studies which found that trading volume goes down when there is extreme weather, investors trade less when they think their local city is more polluted than Beijing and vice versa.

In sum, our study found that air quality, an environmental factor, can influence people’s mood and hence biases in investor trading – specifically stock price and trading volume – beyond that of stock market fundamentals.