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May 01, 2023


Different investors have different tolerance to risk. Other than age, goals and preferences, risk return tradeoff also affects investors’ decision on risky investments.  According to John and Luis (2005), risk-return tradeoff explains that level of return from an investment should increase with increase in risk levels. Therefore, a risk aggressive investor in a higher risk investment does so in anticipation of greater probability of high returns and one who is risk averse opts for lower risks investment and would expect lower returns.

Efficient Market Hypothesis suggests that investors in the market are rational and price of assets can reflect fully their fair value (Fama 1970). Since the evolution of this theory, financial theory has developed drastically. More and more phenomena on the financial markets have prompted financial scientists to carry out more study on traditional finance. Ricciardi and Simon (2000) identify behavioral finance as the cognitive factors and emotional issues that affect the decision making process of individuals. This brings about the element of investor sentiment that drives the attitude of investor towards a particular stock.

Several studies have shown interest in investor behavior and the impact on investment decisions. Yu and Yuan (2011) investigates the influence investor sentiment have on the market mean-variance tradeoff. According to this study, stock market expected return is positively related to market’s variance in low-sentiment periods. However, in high sentiment period, the expected return has no relationship with variance. These investors during high sentiment period undermine a positive mean variance tradeoff. Negative correlation between returns and volatility innovation is therefore much stronger in low-sentiment periods.

Wang (2018a) further probes into the impact of investor sentiment on the mean variance relationship in fourteen European stock markets. The study tends to look into the fact that miss estimating risk can distort the mean variance relationship. From the study, it is established that high sentiment period undermines risk return tradeoff.  This is due to unwillingness of investor to take a short position therefore exerting huge impact on the stock market. It is also noted that  investor sentiment on mean variance relationship is not supported in all markets but specific ones. For this reason, investor optimism is more determined by normal sentiment state. Investor decision on stock trading depends on nominal sentiment level disclosed by sentiment surveys as well as sentiment levels relative to the normal sentiment state.

Another study is carried out on the role of institutional investor sentiment in the mean variance relation Wang 2018b.   the empirical results of the study found some contrasting relatoionship with Yu and Yuan (2018).  Here, the market returns were found to be negatively correlted to the market conditional volatility in bullish market. The opposite was found in a  bearish market, where there was a positive relationship.

Traditional Finance Theory

Wang and Duxbury (2021) behavior of investor thought to be sophisticated and rational. The study sought to identify the impact of investor sentiment on the mean-variance relationship the CCI index was used for investor sentiment and 50 global stock markets was used.  The results showed that there is a negative relationship between investor sentiment and the future returns on a global level.  The study also, wanted to understand impact of the investor sentiment on developed and developing nations. However, the negative patterns are not disrupted in the developed and developing nations.  They discovered that there is an instant impact on the developing nations but there is a more enduring effect on the already developed nations.  They also, evaluated the impact on the individual stock markets and there was heterogeneity in the returns. They attributed this to the differences in cultures among the various markets.

Evidently, there is a difference in the relationship between investor sentiment and the mean-variance relationship.v

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