Feedback Trading, Investor Sentiment and the Volatility Puzzle: An Infinite Theoretical Framework

Abstract

This article constructs a behavioral financial model that provides feedback on both historical prices and company fundamentals without considering asset liquidation to discuss the long-term impact of investor sentiment and feedback trading on asset price fluctuations. The research conclusion shows that the abnormal volatility of asset prices is captured by the value effect, the cognitive bias effect, the sentiment shock effect, and the trading inductive effect. The value effect is the volatility of asset prices that is completely determined by fundamental factors; the higher the degree of cyclical fluctuations in fundamental factors, the higher the volatility of prices. The bias effect refers to investors’ misreading of basic information and trends in asset prices; the greater the instability of emotional shocks, the greater the abnormal volatility of asset prices. The trading inductive effect is also called the Keynes effect, which reflects the role played by rational traders.