Investor sentiment, momentum, and stock returns: an examination for direct and indirect effects

Abstract

This paper aims to analyse the impact of behavioural biases on asset pricing by hypothesising that sentiment and momentum are relevant risk factors in Pakistan equity market. The paper also examines the influence of sentiment and momentum factors on market risk, size, and value premiums by estimating the interacted asset-pricing model. To carry out the empirical analysis, monthly stock returns of firms listed on Pakistan Stock Exchange are used for the period 2000-2013. The empirical results indicate that both investor sentiment and momentum factors have a significant impact on the required rate of returns. Specifically, it is found that the premium for both factors is positive and statistically significant. Further, the estimated results provide evidence that the inclusion of these two factors in the Fama-French three-factor model considerably increases the prediction power of the model. The results also reveal that the inclusion of sentiment factor in the Carhart four-factor model significantly increases the prediction power of the model. Yet, the estimation results indicate that the prediction power of the model further increases when the interaction terms are added to the model in order to examine the indirect effects of sentiment and momentum. The results of the interacted model provide evidence of a significant impact of investor sentiment and momentum factors on market risk, size, and value premiums. Although investor sentiment negatively affects all the three premiums, the effect of momentum is positive for both market risk and size premium, whereas, it is negative for value premium. The findings are helpful in explaining and understanding the effects of behavioural biases on stock returns in Pakistan. The findings of the indirect effects suggest that investor sentiment and momentum factors significantly increase the chance of mispricing in Pakistan equity market.

Mediating Role of Risk Perception Between Behavioral Biases and Investor’s Investment Decisions

“…Ahmed et al (2019) measure the herding behavior in Pakistani financial market through secondary data and found the significant herding behavior. In this connection, Rashid et al (2019) reported that investors’ sentiment and momentum factors significantly impact the market risk, size, and value premiums in the prediction of stock returns.…”

Dynamic Spillover Effects of Investor Sentiment and Return between China and the United States

“…Han and Li [26] reveal that investor sentiment can predict China's stock market returns in the short term, different from the United States and other developed financial markets; and China's investor sentiment is a reliable momentum indicator for predicting monthly market returns; therefore, they propose a profitable trading strategy based on China's investor sentiment. Rashid et al [27] find investor sentiment has a significant impact on the required rate of returns. Baker et al [17]; Hribar and Mcinnis [28]; Stambaugh et al [11]; Neely et al [29]; and Baek [30] obtain similar conclusions.…”

Investor Sentiment and Stock Market Return of Non-Financial Firms Listed on the Nairobi Securities Exchange

“…The theory assumed that no investor has insider information concerning the market and this may not apply. In addition, other factors that make it difficult for the efficient market hypothesis to hold, such as market fluctuation and economic instability and forecasting about stock prices (Rashid, Fayyaz & Karim 2019;Dalika & Seetharam 2015;Alajekwu, Obialor & Okoro (2017).…”

“…In Pakistan, Rashid, Fayyaz and Karim (2019) examined the influence of investor sentiment on stock market returns. The secondary data was obtained from listed firms on the Pakistan Stock Exchange for thirteen years (2000)(2001)(2002)(2003)(2004)(2005)(2006)(2007)(2008)(2009)(2010)(2011)(2012)(2013).…”

“…When sentiment is low, subsequent returns are relatively high on smaller stocks, high volatility stocks, extreme growth stocks and young stocks. It is worth noting that whereas investor sentiment was measured using three ratios namely price-earnings ratio, initial public offering, and discount rate in the study by Rashid, Fayyaz and Karim (2019), Dalika and Seetharam (2015) used four ratios namely volatility premium, the total volume of IPOs, average initial first day returns of IPOs and market turnover.…”