Abstract
Understanding the irrational sentiments of the market participants is necessary for making good investment decisions. Despite the recent academic effort to examine the role of investors’ sentiments in market dynamics, there is a lack of consensus in delineating the structural aspect of market sentiments. This research is an attempt to address this gap. The study explores the role of irrational investors’ sentiments in determining stock market volatility. By employing monthly data on market-related implicit indices, we constructed an irrational sentiment index using principal component analysis. This sentiment index was modelled in the GARCH and Granger causality framework to analyse its contribution to volatility. The results showed that irrational sentiment significantly causes excess market volatility. Moreover, the study indicates that the asymmetrical aspects of an inefficient market contribute to excess volatility and returns. The findings are crucial for retail investors as well as portfolio managers seeking to make an optimum portfolio to maximise profits.
Highlights
There has been growing academic attention in the past decade on investors’ sentiments and their potential impact on market performance
The positive sentiment index has a positive effect on excess market return, but the intensity of negative sentiment is less on negative returns
The findings reveal that investors consider the market as weak-efficient
Summary
There has been growing academic attention in the past decade on investors’ sentiments and their potential impact on market performance. The use of a constructed sentiment index under the GARCH framework to estimate the association between stock market volatility and investor sentiment makes this study different from existing studies. Literature review The development of behavioural finance theories triggered a discussion on the impact of investor sentiment on asset returns in the integrated stock market.
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