Investor sentiment index expanded: From excessive optimism to anchoring and risk aversion

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School of Business | Master's thesis

Date

2019

Major/Subject

Mcode

Degree programme

Finance

Language

en

Pages

86 + 3

Series

Abstract

A reliable measure of investor sentiment would help market participants detect investor sentiment and arbitrage away its effects on asset prices. Baker & Wurgler (2007) introduced a sentiment index which measures systematic market-level investor sentiment. The Baker & Wurgler investor sentiment index (BW sentiment index, SBW) has become widely accepted as a measure of investor sentiment, but it has also been heavily criticized. Some of the critics are worried about the possibility of the sentiment index measuring various economic fundamentals instead of actual sentiment, while others have pointed out that the index could be constructed in a better way to enhance its ability to capture market-wide investor sentiment. In this thesis, I created a new indirect investor sentiment measure based on the original sentiment index of Baker & Wurgler (2007) and Huang et. al. (2015). The focus of the analysis was on studying the US market sentiment index and testing the new sentiment index’s performance in explaining and forecasting the S&P 500 index returns. This study has three main findings. First, adding a proxy for risk aversion substantially improves the aligned sentiment index’s ability to explain US stock market performance. Second, I was not able to create a new index that would serve as a useful proxy for myopic risk aversion, limited attention and anchoring, and adding the index to the definition of the aligned sentiment index does not improve the ability of the index to explain or predict the US stock market performance. Third, adding a proxy for anchoring and limited attention to the aligned sentiment index helps the index predict future US stock market returns slightly better, although not statistically significantly.

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Thesis advisor

Nyberg, Peter

Keywords

investor sentiment, measuring investor behavior, behavioral finance, irrational investor behavior

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