Investor Sentiment vs. Conventional Market Wisdom

By Chuck Benda

The world of finance is full of truisms, axioms, and so-called conventional market wisdom. Among the most basic and prevalent examples of these is the “mean variance theory of asset allocation,” developed in the 1950s by Nobel Prize-winning U.S. American economist Harry Markowitz. In a nutshell, mean variance theory establishes a method for selecting a diverse portfolio based partially on the assumptions that investors:

1. act in a rational fashion; and

2. expect a direct correlation between the risk associated with the investment asset and the rate of return they expect to receive.

Billions of dollars have been—and continue to be—invested based at least in part on perceived investor expectations for risk/reward tradeoff. The trouble is, however, the market doesn’t really work that way according to recent research findings by Carlson School Assistant Professor of Finance Jianfeng Yu and his colleague, University of Iowa Assistant Professor Yu Yuan. In fact, according to their research, you might do better by flipping a coin than assuming the risk/reward tradeoff is always at work in the stock market.

“Almost half of the time, you will find that the market doesn’t demand a corresponding level of compensation for the high level of risk that buyers are assuming,” says Yu. “When investor sentiment, which is the degree of optimism or pessimism about the stock market not justified by fundamentals, is low, the traditional assumptions about risk and reward hold true. In fact, our research suggests that investors who are willing to accept one standard deviation of higher risk can expect their annual return to increase by 12 percent.”

Conversely, when investor sentiment is high, the market becomes willing to accept lower returns for riskier stocks than it otherwise would.

As a result, the heavy presence of sentiment-driven investors during periods of market optimism undermines the otherwise positive mean-variance tradeoff in the stock market.

Yu’s bottom line? Investors should take note. “Asset management firms should consider reducing their holdings on high-risk stocks during high sentiment periods since the risk tolerated during these periods is poorly compensated,” he explains. “Moreover, our results suggest that models of stock prices and risk-return tradeoff should integrate investor sentiment and assign it a significant role.”