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Investor sentiment and stock return predictability: The power of ignorance

Catherine D'Hondt and Patrick Roger

Finance, 2017, vol. 38, issue 2, 7-37

Abstract: Sentiment measures, based on the trading 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 in their choices when answering MiFID questionnaires, especially in terms of their appetite for information and professional recommendations. Our data covers 51 months from January 2008 to March 2012. We show that the sentiment of investors who disregard free information and professional advice is the best predictor of future returns on a long-short portfolio based on size. Our findings remain valid when controlling for investor characteristics like spoken language (French or Dutch), portfolio value and financial literacy. Our results bring evidence that sentiment is essentially driven by underdiversification and narrow framing by retail investors. When shared by many investors, sentiment can generate long-lived mispricing, which is, therefore, difficult to arbitrage.

Keywords: investor sentiment; underdiversification; information seeking; recommendations; retail investors (search for similar items in EconPapers)
Date: 2017
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