INVESTOR SENTIMENT AND THE MAX EFFECT

Abstract

Recent studies suggest that investor sentiment drives the expected stock returns in the cross-section. In this study, we examine whether the overpricing of stocks with high maximum daily returns in the prior month is consistent with such conjectures. Motivated by studies showing individual investors’ preference for stocks with lottery-type features, as well as institutional investors’ aversion for such stocks, we further examine the role of institutional ownership on the returns generating process. We find that stocks with high maximum daily returns in the prior month earn significantly lower returns when investor sentiment is high, but do not underperform when investor sentiment is low. Our results also show that investor sentiment exhibit a broad influence in the stock market and affect stocks with various degrees of institutional ownership. The empirical results further suggest that investors do not require compensation for benchmark risk factors as they actively seek for stocks with extreme positive returns, consistent with theoretical models of gambling preferences.