The Risk–Return–Sentiment Nexus: Dealing with Low Power and Big Bias

36 Pages Posted: 20 Nov 2018

See all articles by Minh Phuong Doan

Minh Phuong Doan

Deakin University - School of Accounting, Economics and Finance

Piet Sercu

FEB at KU Leuven

Date Written: July 28, 2018

Abstract

When regressing return on variance, does a low coefficient necessarily indicate low risk-aversion? Considering CAPM tests conditional on investor sentiment, like in Yu and Yuan [2011], we find that the familiar power issue in single-equation CAPM tests is exacerbated when sentiment is high: the expected return is obscured by a higher variance, the predictors of risk exhibit less variation over time, and even more of that variation is noise (attenuation bias). When, following French, Schwert, and Stambaugh [1987], we add the change of risk as a regressor (to control for flight-for-quality effects and obtain 'indirect evidence' of risk aversion) the conclusions of the regression even self-contradict.

For a cleaner answer we propose to start, instead, from a Taylor expansion of the stock's price, which induces as regressors the changes in variance, expected earnings, the risk-free rate, and longer-term earnings growth. The coefficient of the change of risk is closer to zero than it is in the extended-CAPM regression, and implies a plausible level RRA. It is also closer to zero when sentiment is high, but this can be fully explained by a lower and shorter-lived predictive power of the proxy conditional on high sentiment; we do not need lower risk aversion to explain this, in short. In fact, the implied point estimate of RRA for high sentiment is higher, not lower.

Suggested Citation

Doan, Minh Phuong and Sercu, Piet M. F. A., The Risk–Return–Sentiment Nexus: Dealing with Low Power and Big Bias (July 28, 2018). 31st Australasian Finance and Banking Conference 2018, Available at SSRN: https://ssrn.com/abstract=3223286 or http://dx.doi.org/10.2139/ssrn.3223286

Minh Phuong Doan (Contact Author)

Deakin University - School of Accounting, Economics and Finance

221 Burwood Highway
Burwood, Victoria 3215
Australia

Piet M. F. A. Sercu

FEB at KU Leuven ( email )

Naamsestraat 69
Faculty of Economics and Business
Leuven, 3000
Belgium
+32 16 32 67 56 (Phone)
+32 16 32 67 32 (Fax)

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