Skin in the game – investor behavior in asset pricing, the Indian context

Abstract

PurposeThe purpose of this paper is to investigate investor behavior under two broad categories, market-wide sentiment and herding.Design/methodology/approachUsing a dynamic factor model, that extracts distinct latent factors representing fluctuations in asset returns due to changes in fundamentals as well as investors’ sentiments, the paper investigates the impact of investor behavior on asset pricing.FindingsConsistent with the literature, the results suggest that the behavioral factors play a significant role in explaining variation in the asset prices. However, the degree of influence depends on the nature of the stocks or portfolios. The findings conform to the hypothesis that behavioral factors play a more important role in explaining the price movements of high and medium valued stocks than those of smaller valued stocks. Further, the behavioral factors also exhibit high auto-correlation, depicting the pervasive nature of such factors, and proving that information cascades and other behavioral mechanisms propagate over a period of time leading to bubbles and market crashes. Finally, since herding is often associated with market volatility, the authors test the hypothesis using two measures of volatility and the result shows positive significant associations between them as suggested in the literature.Originality/valueThe paper presents a dynamic factor model to study the impact of investor behavior on asset returns using a conventional three factors model with behavioral factors. A factor model is proposed to extract distinct latent factors representing fluctuations in asset returns due to changes in fundamentals as well as investors’ sentiments. The study investigates investor behavior under two broad categories, market-wide sentiment and herding. Consistent with the literature, the results suggest that the behavioral factors play a significant role in explaining variation in the asset prices. However, the degree of influence depends on the nature of the stocks or portfolios. The findings conform to the hypothesis that behavioral factors play a more important role in explaining the price movements of high and medium valued stocks than those of smaller valued stocks. Further, the behavioral factors also exhibit high auto-correlation, depicting the pervasive nature of such factors, and proving that information cascades and other behavioral mechanisms propagate over a period of time leading to bubbles and market crashes.