When to Pick the Losers: Do Sentiment Indicators Improve Dynamic Asset Allocation?

33 Pages Posted: 8 Mar 2006

See all articles by Devraj Basu

Devraj Basu

SKEMA Business School - Lille Campus

Chi-Hsiou Daniel Hung

University of Glasgow - Adam Smith Business School

Roel C. A. Oomen

Deutsche Bank AG (London); London School of Economics & Political Science (LSE) - Department of Statistics

Alexander Stremme

University of Warwick - Finance Group

Date Written: June 2006

Abstract

Recent finance research that draws on behavioral psychology suggests that investors systematically make errors in forming expectations about asset returns, and thus that investor sentiment can have predictive power for asset returns. A number of empirical studies using both market and survey data as proxies for investor sentiment have found support for these theories. In this study we investigate whether investor sentiment as measured by a component of the University of Michigan survey can help improve dynamic asset allocation over and above the improvement achieved based on commonly used business cycle indicators. We find that the addition of sentiment variables to business cycle indicators considerably improves the performance of dynamically managed portfolio strategies, both for a standard market-timer as well as for a momentum-type investor. Sentiment-based dynamic trading strategies, even out-of-sample, would not have incurred any significant losses during the October 1987 crash or the collapse of the `dot.com' bubble in late 2000. In contrast, standard business cycle indicators fail to predict these events, so that investors relying on these variables alone would have incurred significant losses. These strategies seem to systematically exploit investor over-reaction and are `active alpha' strategies with low betas and high alphas, in contrast to business cycle based strategies which are effectively `index-trackers' with high betas and considerably lower alphas.

Keywords: Investor Sentiment, Dynamic Asset Allocation

JEL Classification: C32, F39, G11, G12

Suggested Citation

Basu, Devraj and Hung, Chi-Hsiou Daniel and Oomen, Roel C.A. and Stremme, Alexander, When to Pick the Losers: Do Sentiment Indicators Improve Dynamic Asset Allocation? (June 2006). EFA 2006 Zurich Meetings Paper; Cass Business School Research Paper; Durham Business School Working Paper. Available at SSRN: https://ssrn.com/abstract=889006 or http://dx.doi.org/10.2139/ssrn.889006

Devraj Basu

SKEMA Business School - Lille Campus ( email )

Avenue Willy Brandt, Euralille
Lille, 59777
France

Chi-Hsiou Daniel Hung (Contact Author)

University of Glasgow - Adam Smith Business School ( email )

Gilbert Scott Building
University of Glasgow
Glasgow, Scotland G12 8QQ
United Kingdom

Roel C.A. Oomen

Deutsche Bank AG (London) ( email )

Winchester House
1 Great Winchester Street
London, EC2N 2DB
United Kingdom

London School of Economics & Political Science (LSE) - Department of Statistics ( email )

Houghton Street
London, England WC2A 2AE
United Kingdom

Alexander Stremme

University of Warwick - Finance Group ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain
+44 (0) 2476 - 522 066 (Phone)
+44 (0) 2476 - 523 779 (Fax)

Register to save articles to
your library

Register

Paper statistics

Downloads
650
Abstract Views
3,079
rank
39,818
PlumX Metrics