INVESTOR SENTIMENT AND TYPES OF INVESTORS

Abstract

One of the most significant empirical findings in the behavioural finance literature is that investor sentiment affects asset prices. However, the mechanism by which sentiment affects asset prices is not well understood. This paper investigates whether individuals or institutional investors, or both, drive the relation between investor sentiment and future returns. Empirical results show that as institutional ownership increases, the impact of sentiment on future returns reduces. The results remain robust after controlling for firm size and sentiment beta. This provides evidence that individuals are sentiment traders while institutions help to mitigate sentiment-related mispricing and increase market efficiency. Recognising that institutional investors are not homogenous, I perform the same test for different types of institutions based on their investment horizon. The empirical results show that both short and long horizon investors are sophisticated and help to mitigate the impact of sentiment on stock prices. This suggests that investment horizon of institutional investors is not the key factor in whether institutions trade to mitigate the impact of sentiment. The main implication of my results is that the impact of sentiment on stock prices is mainly driven by individual investors.