Academic journal article International Journal of Management

A Review of the Effects of Investor Sentiment on Financial Markets: Implications for Investors

Academic journal article International Journal of Management

A Review of the Effects of Investor Sentiment on Financial Markets: Implications for Investors

Article excerpt

Theoretically investors are thought to be rational under EMH; however, in early papers irrational investors, named as noise traders, were not been paid much attention. Based upon the studies of De Long et al (1990) and Lee et al (2002), noise traders have influences on the price formation of assets and conditional volatility. Excess returns of stocks are also affected by investor sentiment. This study provides a review of the effects of investor sentiment on financial markets. There are three suggestions for investors while making investment decisions. First, investors should take a contrarian investment strategy to gain excess returns. Second, small capital stocks are more suitable for investors who can bear larger risk. Third, undervalued stocks should be chosen to gain higher returns.

Introduction

The efficient markets hypothesis (EMH) has dominated the field of finance for nearly thirty years. Fama (1970) defined the efficient market as a market in which security prices always fully reflect the available information. The EMH rests on three arguments (Shleifer, 2000). First, investors are assumed to be rational and value securities rationally all the time. Second, even if some investors trade irrationally, they would trade in a random way. Their trading strategies are not correlated with others and those trades are likely to cancel others out. In other words, the irrational trading decisions do not have influences on prices of securities. Finally, some investors do not trade randomly, but they probably make decisions in similar ways. Consequently, the prices of securities would be overpriced or underpriced. However, the deviation of prices would not last for a long time because arbitrageurs would trade against noise traders to make profits and finally arbitrageurs would drive prices of securities close to fundamental values.

Theoretically investors are considered rational under EMH. However, more and more significant evidences suggest that investors do not trade rationally and make smart decisions all the time. Sometimes they would buy or sell the same securities at roughly the same time because they imitate the judgments with other investors or listen to the market rumors. (Shiller, 1984). Sometimes investors overreact to the news of securities. J.M. Keynes (1997) observed that some insignificant investment information had excessive influences on the markets.

Moreover, there are many empirical findings challenging the theoretical statements of EMH. For example, based upon EMH, relevant news is a trigger of movements. However, the prominent market crash on October 17 of 1987 in U.S.A. obviously violates the framework of EMH. Observers could not find any apparent news about the markets at that day. We called such phenomena against EMH as "financial anomalies" or "financial puzzles". Thus financial markets are not expected to be efficient and investors are no longer expected to act rationally all the time. The irrational investment decisions are not some special cases, but they have influences on the formation of prices and are deserved to pay much more attention than before.

Inefficient Empirical Results in Financial Markets

Based upon the study of Kahneman and Riepe (1998), investors rely on some fixed rules and intuition when making financial decisions. Kahneman and Riepe (1998) propose some related cognitive biases and illusions in decision-making, such as overconfidence, optimism, and overreaction to chance events. Actually, many empirical findings suggest considerable evidences of those cognitive biases.

First of all, people would be overconfidence and extrapolate from their past experiences to predict what is likely to happen in the future. The study of De Bondt and Thaler (1985) shows the evidences of overconfidence for investors in investment decisions. De Bondt and Thaler (1985) compare the performances of two groups of companies, extreme losers and extreme winners, and find that the returns of extreme losers are higher than those of the extreme winners. …

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