This exploratory study by Baker M. and Wurgler J. agrees with the school of thought that investors are sentiment inclined and this in turn affects stock prices. Several articles have corroborated this claim, a recent article by Larry Swedroe (2012) states, "There's a strong body of evidence demonstrating that individuals tend to be influenced by investor sentiment." The main aim of the research is to measure investor sentiment and quantify its effect on stock prices (Baker M and Wurgler J, 2007). Even though a "top down" and macro-economic approach was adopted, some factors that are so pertinent to investor sentiment were not discussed. The approach being adopted here entails measurement of aggregate sentiments, reduced-form, and traces its effect to market returns and individual stocks (Baker M and Wurgler J, 2007).
The theory of this study is based on behavioural finance which was defined by Sewell (2007) as the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. There is also the belief that the movement of prices on the exchanges is dependent to a large extent on the mental attitude of the investing and trading public (Selden 1912, cited in Sewell 2007). This theory also argues that there is 'limits to arbitrage', which gives room for investor irrationality to be significant and have a long-term effect on prices. (Rohit, 2006). This theory gives a strong insight into the basis of this research. Investor sentiment exists and it has a strong influence on the stock market. How do we quantify this effect on the stock market? This is a very interesting question the study is trying to answer.
The "top down" approach being adopted further identified classes of stocks that are more prone to investor sentiment than others. The study categorized investors to include those whose judgments are affected by sentiments, otherwise being referred to as the 'Irrational Traders'; while the other class of investors include those whose decisions are not marred by sentiment. Sentiments come into play when there are uncertainties in the variables for determining the net value of a stock where there is a track record. Sentiment does not necessarily mean an upward valuing of a stock; it can also lead to the stock being underpriced.
This research probes further into achieving its aim by discussing how to measure investor sentiments, the class of stock more sensitive to sentiment and to also ascertain if the level of sentiment is a contributory factor in the future when the effect of the sentiment has been eroded.
After identifying the sentiment indices, the study was faced with the challenge of which measures amongst the ones highlighted to choose in quantifying the investor sentiment based on data availability on these indices. This narrowed down the sentiment proxies to be considered to six; trading volume, dividend premium, close-end fund discounts, volume of IPO and first day return, equity share in new shares (Baker M and Wurgler J, 2007). Even though data are available for some of the proxies, some other factors independent of sentiments have cropped up and regularly affected the data over the years. Regression was conducted on the indices to remove the effect of these external factors.
Using the data available for mutual funds on 10 stocks, a three time-series regression was run on the 10 stocks (Baker M and Wurgler J, 2007). This relates volatility of the stocks and the ease or difficulty of arbitrage. In categorizing stocks according to their speculative appeal and the difficulty of arbitrage there was a difficulty in that professional analysts' forecasts which would have been a gauge for speculations was not available dated back to the data gathering time span. This is a limitation to the quality of result.
The study revealed that the effect of general demand for stock funds on monthly returns is higher for higher volatility portfolios, because the stocks there in are harder to arbitrage (Baker M and Wurgler J, 2007). It further proved that when sentiment is low, the average future returns of speculative stocks exceed those of bond-like stocks and when sentiment is high, the average future returns on speculative stocks are on average lower than the returns of bond-like stocks (Baker M and Wurgler J, 2007).
Considering the limitations identified in the process of data gathering and other identified impediments which are not sentiment based which would have distorted the sentiment indices, the research would have been a qualitative one rather than quantitative. In quantitative approach, the upward valuing and downward valuing of a stock are measured against LIBOR which recently was observed to be influenced by the major bank treasury managers in United Kingdom. Some other factors that are pertinent to investor sentiments were also not discussed in the study namely;
Media: The role of the media in influencing investor's decision is a very salient factor that determines the level of investor sentiment. Lots of individual investors form perceptions about stocks based on information they get from the media. A study by Paul C. Tetlock (2007) was able to correlate level of media pessimism to induce pressure on market prices which is consistent with sentiment theories with the assumption that media content is linked to the behaviour of individuals.
Terrorism: Terrorism is a menace ravaging particularly developing countries. Nigeria has been experiencing series of bomb blasts in most parts of the north making it unsafe for businesses to thrive. In response, Julius Berger amongst a lot of other foreign firms shut down their business in that part of the country. This is also taking its turn on the Stock Market as it was reported in The Guardian Nigeria of 15th June (2012:50) that Equity price of some highly capitalized stocks suffered depreciation due to profit taking by investors. The Stock market is experiencing capital flight as lots of foreign investors lose confidence in the market due to insecurity. Relating the claim above with the research by Konstaninos Drakos(2010:128), he stated that "if terrorist attacks were a mood proxy, then their occurrences could be expected to cause investor sentiment to deteriorate and consequently put a downward pressure on stock prices."
These are pointers to the fact that measuring investor sentiments comprehensively are based on some indices which cannot be quantified and as such a qualitative approach would have been more appropriate.
Further research work would be in localizing the effect of investor sentiment in stock markets by country and not generalizing it considering the fact that some of the sentiment proxies mentioned above are economic and sociopolitical.
The word count for this work is 1089.