Abstract
Previous research suggests that investor sentiment has an influence on the market's risk-return trade-off. Noise traders' demand for assets is considered to be risk independent and, as a result, risky assets do not offer a risk premium when demand is high. We show that market risk is only a priced factor of expected fund returns when investor sentiment is low. Furthermore, fund investors seem aware that risk is sometimes not priced. During high sentiment periods, smart investors buy safe funds that subsequently outperform and sell risky funds that subsequently underperform. Our results are statistically and economically significant.
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