Investor Sentiment in the Stock Market

Malcolm  Baker; Jeffrey  Wurgler

Article | Journal of Economic Perspectives

Investor Sentiment in the Stock Market

by Malcolm Baker and Jeffrey Wurgler

Abstract

We examine how investor sentiment affects the cross-section of stock returns. Theory predicts that a broad wave of sentiment will disproportionately affect stocks whose valuations are highly subjective and are difficult to arbitrage. We test this prediction by studying how the cross-section of subsequent stock returns varies with proxies for beginning-of-period investor sentiment. When sentiment is low, subsequent returns are relatively high on smaller stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme-growth stocks, and distressed stocks, consistent with an initial underpricing of these stocks. When sentiment is high, on the other hand, these patterns attenuate or fully reverse. The results are consistent with predictions and appear unlikely to reflect an alternative explanation based on compensation for systematic risk.

Keywords: Financial Markets; Stocks; Investment Return; Valuation; Forecasting and Prediction; Volatility; Price; Risk and Uncertainty; Behavioral Finance;

Format: Print

23 pages

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Citation:

Baker, Malcolm, and Jeffrey Wurgler. "Investor Sentiment in the Stock Market." Journal of Economic Perspectives 21, no. 2 (Spring 2007): 129–151.

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Investor Sentiment in the Stock Market

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