investor sentiment in the stock market - new york university.pdfVIP

Investor Sentiment in the Stock Market Malcolm Baker and Jeffrey Wurgler December 18, 2006 Prepared for the Journal of Economic Perspectives Abstract Real investors and markets are too complicated to be neatly summarized by a few selected biases and trading frictions. The “top down” approach to behavioral finance focuses on the measurement of reduced form, aggregate sentiment and traces its effects to stock returns. It builds on the two broader and more irrefutable assumptions of behavioral finance—sentiment and the limits to arbitrage—to explain which stocks are likely to be most affected by sentiment. In particular, stocks of low capitalization, younger, unprofitable, high volatility, non-dividend paying, growth companies, or stocks of firms in financial distress, are likely to be disproportionately sensitive to broad waves of investor sentiment. We review the theoretical and empirical evidence for these predictions. Malcolm Baker is Associate Professor of Finance, Harvard Business School, Boston, Massachusetts. Jeffrey Wurgler is Associate Professor of Finance, Stern School of Business, New York University, New York, New York. Both authors are Faculty Research Fellows, National Bureau of Economic Research, Cambridge, Massachusetts. Their e-mail addresses are mbaker@ and jwurgler@ , respectively. The history of the stock market is full of events striking enough to earn their own names: the Great Crash of 1929, the Tronics Boom of the early 1960s, the Go-Go Years of the late 1960s, the Nifty Fifty bubble of the early 1970s, and the Black Monday crash of October 1987. Each of these events refers to a dramatic level or change in stock prices that seems to defy explanation. The standard finance model, where unemotional investors always force capital market prices to equal to the rational present value of expected future cash flows, has considerably difficulty fitting these patterns. Researchers in behavioral finance have been workin