Do Institutional Investors and Security Analysts Mitigate the Effects of Investor Sentiment?

Abstract

One of most significant empirical findings in the behavioral finance literature is that investor sentiment affects asset prices. However, the mechanism by which sentiment affects asset prices is not well understood. Individuals are widely believed to be more influenced by sentiment than other investors, and individual noise traders combined with limits to arbitrage could explain sentiment-driven mispricing in stocks. Another explanation for sentiment-driven mispricing is that sentiment affects all market participants. To explore these two possibilities, we investigate decisions made by institutional investors and security analysts. We find that institutional investors tend to increase holdings in, and analysts tend to issue buy recommendations for, firms with subjective values when sentiment is high, even though these firms exhibit lower subsequent stock returns. Furthermore, returns tests show that these decisions by institutional investors and analysts are associated with greater sentiment-related mispricing of stocks. Thus, although we find that sentiment-related mispricing is mitigated when institutional investors and analysts act against it, more often than not they fail to do so.