Investor sentiment in the stock market

Investor sentiment, defined broadly, is a belief about future cash flows and investment risks that is not justified by the facts at hand. The question is no longer whether investor sentiment affects stock prices, but how to measure investor sentiment and quantify its effects. One approach is "bottom up," using biases in individual investor psychology, such as overconfidence, representativeness, and conservatism, to explain how individual investors underreact or overreact to past returns or fundamentals. The investor sentiment approach that we develop in this paper is, by contrast, distinctly "top down" and macroeconomic: we take the origin of investor sentiment as exogenous and focus on its empirical effects. We show that it is quite possible to measure investor sentiment and that waves of sentiment have clearly discernible, important, and regular effects on individual firms and on the stock market as a whole. The top-down approach builds on the two broader and more irrefutable assumptions of behavioral finance - sentiment and the limits to arbitrage - to explain which stocks are likely to be most affected by sentiment. In particular, stocks that are difficult to arbitrage or to value are most affected by sentiment.