Abstract
This study constructs and tests a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by extrapolating past price changes, while other investors hold fully rational beliefs. The contribution of the present work is the inclusion of institutional investor bias. As such it extends theory. But it also conducts econometric tests by using daily survey data on individual and institutional investors’ sentiment on the current economic situation and their future expectations. Empirical findings may imply that institutions’ sentiment reverts quicker to the equilibrium price than individual sentiment, at least with regard to their beliefs on future economic outlook. If studied further with a bigger dataset, it may imply that institutional investors are closer to the rational-decision making mechanism compared to individual investors. The theoretical framework rests on prospect theory. The market studied is the US equity market, however findings and suggestions can be applied to global markets and various financial instruments.
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