Excess Volatility and Mispricing in the Presence of Sentiment and Institutional Investors

Abstract

Against a prediction of standard models, an exacerbation of investor sentiment is often associated with lower stock return volatility in the data. We propose a model that can replicate this empirical pattern by interacting retail investor optimism with institutional benchmarking concerns. Both optimism and benchmarking separately increase the demand for a stock and decrease its risk premium. In contrast, their joint effect on return volatility is more ambiguous, as the transmission of fundamental news to prices combines benchmarking and relative-wealth channels. The latter channel, in particular, can induce a negative and asymmetric relation between investor sentiment and the stock return's excess volatility. It also explains how a greater institutionalization of financial markets can reduce excess volatility and mispricing in the presence of high sentiment.  
We show that these patterns are consistent with the data.

Keywords: Sentiment, Excess Volatility, Mispricing, Benchmarking, Institutional Investors.

JEL Classification: G11, G12, G18, G41.