Forecasting returns is the holy grail of investment – and finance researchers are also interested in whether returns can be predicted because it tells us whether markets are “informationally efficient” (and thinking about this has been rewarded with a Nobel prize in economics). In this post, we give an investor sentiment overview.
What is sentiment?
Consequently, many studies try to forecast returns. Apart from fundamental analysis (trying to identify and evaluate key value drivers of firms), academics have used investor sentiment to predict asset prices since the seventies (Branch, 1976). The two most widely used definitions of sentiment in Finance are “the propensity to speculate”, and “pessimism or optimism about stocks in general” (Baker and Wurgler, 2006).
The importance of sentiment
Why is it important to talk about investor sentiment? When it captures more than economic fundamentals, it is a sign of irrational behavior. If certain investor groups are prone to such irrational behavior, other groups can exploit this by adopting sentiment-based strategies. Retail investors are candidates for irrational behavior, which the more sophisticated institutional investors may exploit. In fact, institutional investors take retail investor sentiment into account when investing, and their sentiment-based strategies yield profit (Schmeling, 2007). But even retail investors can exploit sentiment based strategies.
How can you measure investor sentiment? Some studies use direct indicators, obtained from surveys, such as the Sentix or Consumer Confidence Index. Others use market variables as indirect indicators: volatility indices, or the put/call ratio (PCR, number of put options divided by number of call options traded). How can you interpret such indicators? For PCR, a high level indicates that more investors express a bearish opinion than a bullish opinion regarding the market. Empirical studies mostly use the PCR as a contrarian signal: you should take a position opposed to the market’s irrational behavior.
Different investor groups have different sentiment
But how do you identify the sentiment of the irrational group? This becomes more involved. Assume, e.g., that you want to measure retail investor sentiment. Then, using indirect indicators derived from Futures contracts is a bad choice – retail investors rarely trade Futures. The same applies for direct indicators. Some capture retail investor sentiment (e.g., Sentix survey indicator), while others reflect institutional investor sentiment (e.g., G-Mind survey indicator – Burghardt, 2011).