Applicability of behavioural finance

Abstract

It is believed that investor sentiment is correlated to stock market returns, making consistent positive (or negative) return on stocks investing possible and as such, disreputing the Efficient Market Hypothesis (EMH). Various literatures have put forth the notion that investor sentiment, investing behaviors, or degree of fear (henceforth shall all be known as ‘market sentiment’) is correlated to stock market returns. These researches are done either through mathematical proving and/or through careful analysis of financial surveys. This paper attempts to answer the question: what are some of the most effective ways of measuring the investor sentiments? And are these measures of investor sentiment valid when used to explain market anomalies through the use of Capital Asset Pricing Model (CAPM)? In order to identify the most statistically significant gauges of investors’ behaviors, a few prominent methodologies and its resulting economic indices have been analysed. Specifically, they were the (i) Volatility Index (VIX), (ii) Consumer Sentiment Index (CSI), (iii) Bull-Bear Spread Index (BBS) and the (iv) Investor Sentiment Index (ISI). Relationship between abnormal return represented by the market alpha and the investor sentiment represented by various confidence variables has been constructed. At the end of the paper, the results will show that CSI is the only measure of investor sentiments that can be incorporated into CAPM in explaining the stock alpha.