What Does Investor Sentiment Reflect: Animal Spirits or Risks?

30 Pages Posted: 18 Nov 2012 Last revised: 26 Aug 2013

See all articles by Sungbin Sohn

Sungbin Sohn

Sogang University - Department of Economics

Date Written: June 1, 2013

Abstract

The role of investor sentiment in the stock market has attracted attentions of many economists. Previous papers show that investor sentiment has return predictability and it is more pronounced among stocks that are more difficult to value and/or to arbitrage, and emphasize the behavioral role of investor sentiment. However, it still remains unclear whether this predictability is actually due to a causal effect of autonomous animal spirits or not. Alternatively, investor sentiment may simply reflect systematic risks, which would affect stock returns. In this alternative case, the predictability would be mere coincidence, not causation. In this paper, I try to understand the meaning of innovations in investor sentiment. I use the investor sentiment index constructed by Baker and Wurgler (2006). I set up a structural model in which sentiment innovations arise from both animal spirit shocks and several risk shocks, and animal spirit shocks could affect stock returns. By matching impulse response functions from data simulated by the theoretical model to those from the actual US data, I estimate parameters in the model. The estimated model moderately replicates the historical data in the actual stock market. The estimation results show that a substantial amount of variation in investor sentiment is explained by systematic risk shocks as well as by animal spirit shocks, and that animal spirit shocks can have significant effects on stock returns. The findings suggest that investor sentiment is a noisy proxy of animal spirits and autonomous animal spirits are at least in part responsible for the apparent return predictability of investor sentiment.

Keywords: investor sentiment, animal spirits, systematic risks, simulation, impulse response functions matching

JEL Classification: G02, G12, G17

Suggested Citation

Sohn, Sungbin, What Does Investor Sentiment Reflect: Animal Spirits or Risks? (June 1, 2013). Asian Finance Association (AsFA) 2013 Conference, 26th Australasian Finance and Banking Conference 2013, Available at SSRN: https://ssrn.com/abstract=2177181 or http://dx.doi.org/10.2139/ssrn.2177181

Sungbin Sohn (Contact Author)

Sogang University - Department of Economics ( email )

35 Baekbeom-ro
Seoul, 121-742
Korea

HOME PAGE: http://sites.google.com/view/sungbinsohn

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