Turning the heat on financial decisions: Examining the role temperature plays in the incidence of bias in a time-limited financial market

Many laboratory-based studies provide evidence that temperature can influence how people make decisions, by affecting their risk preferences and propensity to make cognitive errors. However, the role of temperature on the quality of decisions made in real-world settings it is not well-understood. A strand of literature in financial markets has attempted to explore this, but the results have been inconclusive: some studies suggest that temperature does not affect financial decisions, whilst others reach contrasting conclusions – some suggesting that higher, and others that lower temperatures, reduce the quality and economic value of financial decisions. We design an empirical experiment to overcome the limitations of previous studies in order to shed new light on the role of temperature in financial decisions. The study employs data from a time-limited market for state-contingent assets, namely an event-driven prediction market. We assess the extent to which prediction market participants’ subjective judgments of event probabilities deviate from the actual probability of the event occurring, as a result of temperature-induced cognitive errors and risk-taking. The results demonstrate that higher temperatures are associated with lower decision quality. We also found that temperature differentially influences the decisions of those with different decision profiles, with the largest influence observed on individuals whose decisions are based on logic, objectivity and skilful cognitive evaluations of alternatives