Time-varying Impact of Investor Sentiment

Abstract

I present a dynamic equilibrium model of investor sentiment in which investors form beliefs by overly extrapolating past returns. The key contribution of my model is to connect mispricing with investor sentiment through the market impact of extrapolators, and to provide novel insights into the predictability of market returns. When their wealth level is high, extrapolators drive the asset prices. In this case, their high investor sentiment makes the current asset price overvalued, and the future asset price will decline because high investor sentiment will cool down over time. Therefore, investor sentiment negatively predicts future market returns. When extrapolators' wealth level is low, high investor sentiment predicts high future returns since the market is under a price correction. I find strong support for my model in the data. My model also matches investor sentiment in surveys, and it captures many documented patterns of boom-bust cycles in the stock market.

Keywords: Return Extrapolation, Asset Pricing, Return Predictability, Investor Sentiment, Behavioral Finance