Investor Sentiment and Stock Returns: Out of Sample Evidence

Investor Sentiment and Stock Returns: Out of Sample Evidence

Serkan Yılmaz Kandır, Veli Akel, Murat Çetin
DOI: 10.4018/978-1-4666-7484-4.ch019
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In this chapter, the authors investigate the relationship between investor sentiment and stock returns in an out of sample market, namely Borsa Istanbul. The authors use the Consumer Confidence Index as an investor sentiment proxy, while utilizing BIST Second National Index as a measure of small capitalized stock returns. The sample period spans from January 2004 to May 2014. By using monthly data, the authors employ cointegration test and error–correction based Granger causality models. The authors' findings suggest that there is a long-term relationship between investor sentiment and stock returns in Borsa Istanbul. Moreover, a unidirectional causal relationship from investor sentiment to stock returns is also found.
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Investor Sentiment

Behavioral finance approach includes a number of sub-theories. The term “noise” has a unique position among these theories. The term noise is originated by Black (1986) and it refers to “incorrect signals” shared among the participants of the capital markets. The investors who try to exploit noise are called noise traders. Moreover, noise trading cannot be attributed to specific group investors. On the contrary, noise trading may have a pervasive character across the capital markets. Thus, diversifying the noise originated security price deviations would not be possible. In this manner, noise would earn a systematic character as a source of risk and it should be involved in the return generation processes. Limited arbitrage makes it easier for noise trading to impact asset prices (Shleifer & Summers, 1990).

Although noise introduces additional risks, investors in fact benefits from its existence. As noise originates from incorrect signals, information reflects the correct signals in the market. However, the potential problem arises from the correctness of the signals reaching the marketplace. If every market participant trades on the correct signals, nobody would find counterparty. Since all participants share the very same information, all expectations regarding the future would be the same. This harmony in expectations would prevent security trades. Nevertheless, if some of the participants make noisy decisions, they would constitute ideal counterparties for rational investors. As a result, we may expect a positive association between the volume of noise trading and the liquidity of the general market. However, since the correct signals do not guarantee a good return, rational investors would not be able to fully exploit the incorrect expectations of the noise traders. Security prices would always reflect noise as well as information (Black, 1986, p.530-532).

Key Terms in this Chapter

Behavioral Finance: A study of the way in which psychology inflences the behavior of market practitioners, both at the individual and group level, and the subsequent effect on markets.

Investor Sentiment: A belief about future cash flows and investment risks that is not justified by the facts at hand.

Consumer Confidence Index: An economic indicator that reflects the expectations of consumers for the future.

Borsa Istanbul: Borsa Istanbul brings together all the exchanges operating in the Turkish capital markets under a single roof.

Stock Returns: The gain or loss of a stock in a particular period.

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