Portfolio Diversification Dynamics as a Measure of Market Sentiment
Strasbourg University - LARGE Research Center - EM Strasbourg Business School
June 10, 2012
Midwest Finance Association 2012 Annual Meetings Paper
We build an original market sentiment index based solely on changes over time in the number of different stocks held by individual investors. No prices, returns or trading volumes enter the definition. As a consequence, our index is not contaminated by liquidity concerns present in measures based on buy-sell imbalances.
Using the trades and portfolios of a large sample of ninety thousand investors over a eight-year period, we show that our index outperforms other usual indices (based on surveys, macro-economic variables or buy-sell imbalances) in predicting returns on long-short size-based portfolios. Moreover, a simple dynamic strategy driven by our sentiment index delivers a Sharpe ratio higher than that of ninety nine percent of random dynamic strategies and much higher than the Sharpe ratio of a buy-and-hold strategy. The predictive performance of our market sentiment index survives several robustness checks, including restrictions on the minimum portfolio value of individual investors and constraints on the number of states of the Markov chain used to model the time-series of diversification levels.
Number of Pages in PDF File: 32
Keywords: Investor Sentiment, Retail Investors, Buy-Sell imbalance, Markov Chains
JEL Classification: G11, G14working papers series
Date posted: September 15, 2011 ; Last revised: June 11, 2012
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