Measuring investor sentiment in equity markets

Traditional research on asset pricing has focused on fundamental, firm-specific and economy-wide factors that affect asset prices. Recently, however, some researchers have turned to investor psychology to explain asset-price behaviour. It was previously assumed that there is little correlation among the sentiments of investors. The differing sentiments thus offset each other, and there is no resulting effect on market prices. If, however, there is enough of a consensus among investors, their viewpoints will not offset and will instead become an integral part of the price-setting process. In fact, some researchers (eg Eichengreen and Mody 1998) suggest that a change in one set of asset prices may, especially in the short run, trigger changes elsewhere, because such a change engenders shifts in the market’s attitude towards risk (ie because there is a change in investor sentiment). Such shifts in risk attitudes may explain short-term movements in asset prices better than any other set of fundamental factors (eg see Baek et al. (2005). Other studies have also recognised that investor sentiment may be an important component of the market pricing process (see Fisher and Statman, 2000; Baker and Wurgler, 2006).