The Real Effects of Investor Sentiment
69 Pages Posted: 30 Nov 2002
Date Written: November 2002
Does inefficiency of financial markets have real consequences? Or does it only result in transfers of wealth from noise traders to arbitrageurs? We study firm business investment to address this question. In our model, benevolent managers of overvalued companies invest in projects with negative net present value and managers of undervalued companies forego projects with positive net present value. Empirically, we find a positive relation between investment and a number of proxies for mispricing, controlling for investment opportunities and financial slack, suggesting that overpriced (underpriced) firms tend to overinvest (underinvest). Consistent with the predictions of our model, we find that investment is more sensitive to mispricing for firms with higher R&D intensity (suggesting longer periods of information asymmetry) or share turnover (suggesting that the firms' shareholders are short-term investors). We document similar patterns in the cross-section of average returns. Firms with relatively high (low) investment subsequently have relatively low (high) stock returns, after controlling for investment opportunities and other characteristics linked to return predictability. These patterns are stronger for firms with higher R&D intensity or higher share turnover.
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