Investor sentiment and stock return predictability: The power of ignorance

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A number of papers show that investor sentiment measures based on the market activity of retail investors carry some predictive power of future market returns. In this paper, we use such a sentiment measure on two samples of approximately 25,000 individual investors, who differ by their appetite for information and professional recommendations. Our data cover 51 months from January 2008 to March 2012. We show that the sentiment of investors who neglect either free information or professional advice has more power in predicting future returns than the sentiment of investors who access to more information and recommendations. Our findings remain valid when controlling for investor characteristics like spoken language (French or Dutch), for investor portfolio value, and for investor self-reported financial literacy. Our results suggest that market sentiment essentially refers to the fast and automatic System-1 reasoning. When shared by many investors, sentiment can generate long-lived mispricing that is therefore difficult to arbitrage.

Author(s):

Catherine D'Hondt    
Louvain School of Management, Catholic University of Louvain
Belgium

Patrick Roger    
EM Strasbourg Business School, University of Strasbourg
France