VJM

2017, Vol. 03(1) 77-91

Copyright © University of Sri Jayewardenepura
ISSN 2448-9344
ISBN 978-955-23-0019-3
Reprints and permissions:
[email protected]

Investor Sentiment and Asset Pricing: A Review

C. Gunathilaka
University of Sri Jayewardenepura, Sri Lanka

Abstract
This paper reviews literature on asset pricing and investor sentiment. It
provides a fair accumulation of evidence with an objective of showing how
productive has been the effort of modelling market sentiment in pricing assets.
Research efforts in modelling non-standard investor behaviour have been
successful in explaining aggregate predictability. However, despite the
financial innovations and discussions on investor sentiment that happened in
US markets, empirical work in emerging markets is still preliminary. The
paper inquires the extent that the existing asset pricing models price the
assets in the economy.

Keywords
Investor, Pricing, Returns, Sentiment

Introduction
This paper surveys literature on investor sentiment, risk factors, and asset
pricing with an objective of showing how productive has been the recent
sentiment and asset pricing research. Any attempt of this nature must
necessarily have limitations, as the field is large and active over several
decades. I do not survey the efficiency of pricing models, instead
concentrating on the sentiment embedded pricing models that have been

Corresponding Author:
Dr. Chandana Gunathilaka is a Senior Lecturer at the Department of Finance, University of Sri
Jayewardenepura, Nugegoda, Sri Lanka. E-mail: [email protected]
 GUNATHILAKA

found successful in different markets. In particular, behavioural research is at

its infancy in the Sri Lankan capital market, and there is no substantial
empirical work on sentiment to the best of the author’s knowledge. This effort
may be of importance to the future of related research in shifting the body of
knowledge.

Risk Factors
Research seeks for a Stochastic Discount Factor that prices all assets in the
economy (Campbel, 2000). For roughly the last five decades, asset pricing
has been an active area of research in financial economics. The Capital Assets
Pricing Model (CAPM) (Sharpe, 1964) and Arbitrage Pricing Theory (Ross,
1976) do represent the prominent mainstream pricing models, however,
empirical evidence contradicts with central explanations of them. A potential
reason claimed for the inconsistency is investor heterogeneity and
irrationality. The hypothesis that there are fully rational participants in the
market (Fama, 1976) expects an asset’s price at fundamental value. As long
as investors are rational and markets are perfect, there can be less possibility
of mispricing (Hirshleifer, 2001). CAPM has no concern for the prior
thoughts that the individual psychology affects prices (Hirshleifer,
2001).Fama and French (1992) find that the cross section of average equity
returns shows only a marginal relationship to the beta of CAPM. In response,
Fama and French (1993) use effects of size and value in a three-factor model.
However, firms with similar size and book-to-market tend to perform better
(or not) together because their exposure is similar (Daniel & Titman, 1997).
Fama and French (2015) show that size and value leave a substantial
unexplained component in returns in cross section.

In search for risk factors, research documents predictability of stock

returns through market anomalies. These include the effects of value
(Resenberg et al., 1985), size (Banz, 1981), momentum (Jagadeesh & Titman,
1993), and illiquidity (Amihud & Mendoloson, 1986). While CAPM explains
the variation by market risk, evidence shows a better performance of the Fama
and French (1993) model, which uses size and value risk factors. However,
its supremacy among other pricing suggestions in general is inconclusive
(Rahim & Nor, 2006). For instance, Jensen et al. (1997) argue that size and
value effects depend largely on the monetary environment and they are
significant only in expansive monetary policy periods. Laubscher (2002), in

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his review paper, warns investors on application of CAPM in evaluating

investment performance because many other factors influence return of
stocks. However, authors also warn that unconditional empirical tests on
CAPM may reject CAPM even if it holds perfectly (Lewellen & Nagel, 2006).
They test conditional CAPM with Momentum and Value, and argue that
variation in the equity premium would have to be implausibly large to explain
anomalies. Jagannathan and Wang (1996) use yield spread between low and
high quality bonds. However, this proxy has not received subsequent
empirical support. Among the many efforts, the Carhart (1997) model that
extends the Fama French Three factor model with momentum effect
(Jegadeesh & Titman, 1993) has received a wider support.

Human Capital: A further critique of CAPM is that it does not correct the
effect of non-tradable human capital. Human capital is an important
component of wealth (Yuan, 2012) of, say an individual. Jagannathan and
Wang (1996) find that growth rate of aggregate labour income successfully
proxy serves human capital return. Economists identify two benefits of
human capital, marketed and non-marketed. ‘Non-marketed’ include benefits
of activities like exercising, and resting. As the consumption is influenced by
(at least) marketed benefits, it is unreasonable to ignore human capital’s
influence on investment. Yuan (2012) models human wealth with aggregate
labour income, and discovers a theoretical linkage between asset pricing and
unemployment rate. In his five-factor model, Campbell (1996) argues that
expected return of an asset depends on future labour income. Kim, Kim, and
Shin (2012) construct a labour factor, the ‘difference in returns’ between high
and low labour beta stock portfolios. Jagannathan et al. (1998) find that the
market risk of CAPM and labour beta together explain about 3/4th of return
variations. They further explain that the labour beta has the power of driving
out the size effect.

Illiquidity: Among the others, liquidity has been of interest for recent
asset pricing studies. If the liquidity hypothesis holds, low liquidity should
offer high returns. Naturally, the liquidity effect may be more worth studying
in emerging markets, due to relative illiquidity. Lam and Tam (2011) suggest
a four-factor model with liquidity, a best-use model in Hong Kong. This issue
is important since a vast literature exists in the area of market microstructure,
they argue that liquidity has a first-order effect upon asset returns (Marcelo

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& Miralles, 2006). Amihud (2002) find that stock returns are negatively
related to contemporaneous unexpected illiquidity. Narayan and Zheng
(2010) conclude that aggregate illiquidity factor is a key ingredient in asset
pricing, improving the Fama and French (1993) three-factor model. (Nguyen
& Lo, 2013) who claim that empirical evidence on the liquidity–return
relation mainly centres on US markets, report significantly lower returns in
illiquid than liquid stocks, a liquidity discount in New Zealand.

Profitability and Investment Patterns: Fama and French (2015) present

two new risk factors. The difference between the returns on diversified
portfolios of stocks with robust and weak profitability (Robust Minus Weak:
RMW), and the difference between the returns on diversified portfolios of the
stocks of low and high investment firms (Conservative Minus Aggressive:
CMA). However, with introduction of these factors in the five factor model,
the value factor (High Minus Low: HML) becomes redundant (Fama &
French, 2015). HML has no information than what is explained by other four
factors on average returns. This might support the critique that asset-pricing
models suffer from data snooping, manipulation and methodology issues. On
the other hand, a common source might be left unexplained, for instance,
HML might show the link to illiquidity (Jais & Gunathilaka, 2016).
Nevertheless, RMW and CMA factors have not received support from
subsequent studies, Jio and Lilti (2017) find no significant explanatory power
in Chinese market. Nguyen et al. (2015) observe literature that these two
factors merely do not exist in Japan and Asia Pacific portfolios, yet they find
evidence from Vietnam that the five-factor model explains more anomalies.

Investor Sentiment
Standard finance theory has its base on the theoretical work of a few
pioneering scholars. It follows portfolio principles of Markowitz (1952),
Arbitrage principles (Miller & Modigliani, 1958), Capital asset pricing theory
(Sharpe, 1964; Lintner & Black, 1965), and the Option pricing theory (Black
& Scholes, 1973; Merton, 1976). They assume rational markets, and the
decisions comply with the axiom of Expected Utility Theory. Thus, their
forecasts are unbiased, an individual is generally risk averse, and has a
decreasing marginal utility of wealth. Nevertheless, Shiller (1981) shows that
stock prices are responsive to many reasons than new information, and
excessive volatility has roots to investors’ sentiment. Investor sentiment is

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investor opinion, usually influenced by emotions, about future cash flows and
investment risk (Chang et al., 2009). Empirical findings on sentiment impact
(Brown & Cliff, 2004) have created a challenge to the Efficient Market
Hypothesis. Therefore, identification of sentiment based predictable variation
in returns is a considerable debate in modern financial economics (Brown et
al., 2005). Fama (1998) agrees that overreactions to past information could
be a prediction of a behavioural finance alternative to market efficiency.

The question whether investor sentiment has an impact on stock prices is

of foremost importance because investor sentiment can lead to market
bubbles followed by massive devaluations (Finter et al., 2011). Sentiment has
consequences on wealth allocation between low to high-risk firms. Chung et
al. (2012) report sentiment’s sensitivity to stocks with low Book to Market
ratios. Stocks do not uniformly sensitive to market patterns, and firms with
opaque characteristics exhibit high exposure (Berger & Turtle, 2012). Assets
may overprice in response for good news (Daniel et al., 1998). It creates a
problem that the rational investors cannot profit using noise trader mistakes.
This risk can force arbitrageurs to liquidate their positions, causing them
potentially huge losses (Shleifer & Vishny, 1997). Research reveals that
arbitrage is riskier for young stocks (Baker & Wurgler, 2006). Small,
distressed or extreme growth stocks are more sensitive to investor sentiment
and consequently, difficult to arbitrage. Securities those that are difficult to
arbitrage, are also tend to be more difficult to value. Baker and Wurgler
(2007) state that sentiment’s role is significant in market volatility.

The prospect theory of Kahneman and Tversky (1979) is a prominent

theory of decision-making under uncertainty. Investors evaluate outcomes
according to their perception on gains and losses relative to a reference point,
typically the purchase price. They do not concern final wealth levels;
investors are more sensitive to losses than to gains of the same magnitude
(loss aversion); and investors are risk-averse for gains and risk seeking for
losses. Explanations of Baker et al. (2007) on managers’ behaviour are
consistent with prospect theory. Shefrin and Statman (1985) argue that
individuals are more emotional than professional investors are. They are
likely to sell winning stocks too early in order to postpone the regret
associated with realizing a loss. Studies also reveal that momentum profits
are significantly larger when investor sentiment is optimistic (Cooper et al.,

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2004). Hence, sentiment is important, at least for momentum buy-side

transactions. Cooper et al. (2004) further report that loser portfolios in down
markets experience large positive returns (reversals), even though the winner-
loser differential is insignificant.

Measuring Investor Sentiment

Sentiment has no straightforward measure (Baker & Wurgler, 2007), and
both explicit and implicit approaches have been used in prior studies. Brown
and Cliff (2004) measure investor sentiment using investor intelligence
survey, this explicit approach attempts to explain how individual investors
underreact or overreact to past returns or fundamentals through an assessment
of the level of cognitive biases in individual investor psychology. Investor
bias, including frame dependence, mental accounting, representativeness, and
conservatism forms market sentiment. Therefore, this bottom-up approach
uses some realized biases in describing sentiment. Cognitive bias explains
how individual investors under or over react to past returns or fundamentals
(Barberis et al., 1998). Institutional investors use more technical information
and they do fundamental analysis, hence institutional investor sentiments are
more rational than individuals (Verma & Verma, 2008). Some studies
therefore use direct surveys from professional market analysts or fund
managers to measure sentiment. Fisher and Statman (2000) use the Merrill
Lynch Global Fund Managers Survey as a proxy for institutional investor
sentiment. Economists always use surveys with caution as individual investor
opinions would ideally be different from institutional investors. Retail
investor’s confidence on the market is also related to the consumption, for
this reason, Benrephael, Kandel, and Wohl (2012) use the consumer
sentiment index of the University of Michigan in explaining investor
sentiment.

One limitation of the bottom-up approach to sentiment in asset pricing

research is the unavailability of time series of sentiment indicators. Capital
markets in emerging economies feel this absence severely, for instance, Sri
Lanka has no such an indicator. Another critique is that these realized biases
do not reflect the whole market sentiment. Top-down approach is the
alternative, which argues that the real investor characteristics are too
complicated to be described by a few realized biases (Baker & Wurgler,
2007). Market wide variables could better describe the change of investor

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sentiment. This approach is essentially a reduced form of aggregate

sentiment, and attempts to generate indicators using market wide proxies. In
doing this, implicit empirical studies use different proxies and methods.
Bandopadhyaya and Jones (2006) use a risk appetite index, which is the
Spearman Rank Correlation of daily returns and volatility of historical returns
of a security. Baker and Wurgler (2006, 2007) generate an index using six
proxies: Closed-End Fund Discount (CEFD), Turnover (TURN), Number of
IPOs (NIPO), First-day IPO return (RIPO), Premium for dividend paying
stocks (PDPD), and Equity share in new issues (S).

Sentiment Level = -β1CEFD + β2TURN + β3NIPO + β4RIPO- β5PDND + β6S

βi is the first principal component of ith proxy. Because these variables

partially explain economic fundamentals, they argue that the portion
explained by economic fundamentals is a rational component of total
sentiment. Thus, they regress market proxies against six macroeconomic
variables and isolate the irrational component. The sentiment level is the first
principal component of the ‘orthogonalized’ series. However, their
methodology has been observed with estimation errors, the index is likely to
understate the predictive power because it is based on the first principal
component of six proxies that may have a common noise component (Huang
et al., 2013). While these proxies are likely to capture some aspect of
sentiment, they also contain an idiosyncratic, non-sentiment related,
component (see, e.g., Finter et al., 2011). One could find a better proxy, even
though there is no best proxy. Thus, it is interesting to see the success of other
proxies used in the related literature.

The number of news headlines (Cook et al., 2006) in financial or

economic periodicals has the ability to capture market sentiment in US
markets. Additionally, prices in the pre-IPO gray market (Cornelli et al.,
2006), Common component among columnists (Bull-Bear spread: Brown &
Cliff, 2005), and Trading volume (Baker & Stein, 2004) have been successful.
Higher volume may show an optimistic level of investors’ sentiment.
Mahakud (2012) uses a liquidity proxy, turnover velocity. Another commonly
used proxy for market liquidity is the share turnover velocity measured as the
ratio between the electronic order book (EOB) turnover of domestic shares
and their market capitalisation. This works as an indicator of the breadth and

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depth of a market, thus a high ratio indicates better liquidity or bullish

sentiment in the market. Ratio of ‘net buy’ volume to the total volume (Kumar
& Lee, 2006), has been a better indicator of sentiment. Trading volumes of
equity put options to call options (Brown & Cliff, 2004), put/call ratio, works
as a directional bet in the market. Sentiment should be excessively bearish
when the ratio is relatively high, and it should be excessively bullish at low
levels. Brown and Cliff (2004) use ADR calculated as the ratio between the
number of advancing and declining stocks. The rising (declining) values of
the ADR can be used to confirm the upward (downward) trend of the market
(Mahakud, 2012). In markets where short sales are active, investors’ opinion
could be seen through margin finance levels. Therefore, a change in margin
borrowing position serves proxy for bullish sentiment (Brown & Cliff, 2004).
Hirose et al. (2009) find a significant cross-sectional relationship between
margin buying and stock returns in Japan. This indicator has also been
successful in Indian market (Mahakud, 2012). Hirose et al. (2009) observe
that margin traders' herding behaviour seems to influence stock prices in the
following week. Number of IPOs (NIPO) has been used to proxy sentiment
by many studies including Brown and Cliff (2005). More IPO period reflect
a period of demand for new equities and hence an upward sentiment. This
assumption is necessarily a reflection of managers’ confidence over the
market; the issuers take the advantage of market’s confidence over the
upcoming period. Hence, the number of IPOs indicates the judgment of the
managers over investors’ sentiment and the managers’ assessments on
movement of market. Subsequent research (Finter et al., 2011) proposes
NIPO to be one of the better indicator. Furthermore, Changsheng and
Yongfeng (2012) find their NIPO included sentiment model with incremental
explanatory ability for both hot stocks and value stocks in Chinese market.

Following the market timing hypothesis (Baker & Wurgler, 2006) a high
Equity Issuance to Total Issues of debt and equity ratio can be considered as
a bullish market sentiment. Lee et al. (1991) have used dividend premium,
the difference in average market-to-book ratios of dividend payers and non-
payers. In periods of bullish market sentiment, investors do not look at the
dividend payers. However, they demand dividend payers in negative
sentiment. Theoretically, increasing open interest in equity derivatives rising
market (and decreasing in a falling market) is a bullish condition. Similarly,
decreasing open interest in a rising market (and increasing in a falling market)

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is a bearish condition. Hong and Yogo (2012) argue open interest to be more
informative than futures prices in the presence of hedging demand and limited
risk absorption capacity in futures markets. They report furthermore, that
movements in open interest predict returns in stock markets.

The flow of funds for equity mutual fund investments has been
considered as an implicit proxy for investor sentiment (Brown & Cliff, 2004).
This indicator would perform better in a market where equity funds are fully
active. The institutional churn rate for a stock has also been used as a negative
proxy for the degree of investor irrationality for the stock (Chae & Yang,
2006). The argument is that the more trading from institutions, the less trading
from individuals, and the less influence of investor irrationality. This
argument is consistent with prior research that the irrationality persists mostly
among less sophisticated investors, individuals.

Nayak (2010) documents that the bond yield spreads co-vary with
sentiment, and sentiment-driven mispricing and systematic reversal trends are
very similar to those for stocks. This suggests that investors decide wealth
allocations and trade between debt and equity based on their current and
future expectations about the economy’s status. This could perhaps be due to
integrated debt and equity markets where the shifting cost is minimal. Chae
et al. (2006) confirm that transaction costs and investor irrationality are
correlated negatively with performance of asset pricing models.

However, some of these proxies do not make sense in emerging markets,

as the markets are different in size, volume, and operations. Feldman (2010)
suggests a new sentiment measure, Perceived Loss Index, appropriate in
detecting bubbles and financial crises in financial markets. The measure first
assumes loss-averse investors (Kahneman & Tversky, 1979). Loss aversion
means investors are more affected by losses than by gains. Loss aversion
kicks in when investors are hit by losses, so they become more pessimistic
about the reward/risk prospects. Loss aversion subsides when investors
experience gains. Secondly, it assumes that investors place greater weight on
the most current performance. Investors remember the most current loss and
forget losses far in the past. This study is based on mutual fund data recorded
at Center for Research in Security Prices, using over 14,000 US mutual funds.
Thus is a limited application in small markets like Sri Lanka, yet a stimulating

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study that would guide behavioural studies exploring psychology of

investors.

Jiang et al. (2013) calculate Google Search Volume Index (SVI) as used
by Da et al. (2011) who showed that this aggregate Google search measure is
a direct measure of (retail) investor attention. Jiang et al. (2013) calculate
abnormal Google Search Volume Index (ASVI), defined as difference
between search volume during book-building week and its median in
previous eight weeks.

It is also important to note that some of the variables used in developed

markets may be impractical in emerging markets. For instance, ‘Closed End
Fund Discount’ (Baker & Wurgler, 2007) is inappropriate in Malaysian
market (Gunathilaka et al., 2016) and Sri Lankan market due to limited
number of closed end funds and their market activity. Furthermore,
application of total debt issues relative to the equity issues, may produce
insignificant results in markets where debt market is relatively under-
developed. Similarly, put/call ratio is inappropriate in Sri Lanka due to the
equity market’s limited activity. Additionally, the IPO market is inactive in
Sri Lanka, and the indicators from this market would unlikely capture the
market sentiment.

Conclusion
Asset pricing literature suggests numerous risk factors explaining many
market anomalies. However, empirical efforts find mixed results and asset
pricing remains active and relevant for financial economics. Behavioural
finance attempts to bridge the gap between finance and psychology. In recent
years, studies have shown that the investor sentiment has a significant impact
on asset prices. Authors suggest sentiment as a factor in multifactor APT
models. The body of work, including that of Baker and Wurgler (2007), Finter
et al. (2011), Mahakud (2012), and Hilliard and Narayanasamy (2016), shows
that the extended model of Carhart (1997) with sentiment factor produce
significant results. However, these sentiment asset pricing models do consist
of many shortcomings, hence do not possess the generality of analysis.
Knowing the fact that these pricing models are bound imperfect, there is no
fundamental reason why further studies cannot find more generalizable

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sentiment model. In particular, empirical efforts in an emerging context,

given the limitations discussed in this paper, would be of more significance.

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