Emotional Impact Of Idiosyncratic Risk And Expected Return Relationship

The empirical evidence on the cross-sectional relation between idiosyncratic risk and expected stock return is mixed:the traditional theory suggests that idiosyncratic risk can be completely decentralized and will not have an impact on expected returns, because rational investors invest in a diversified portfolio; However, due to the reality that investors are limited rationality and the stock market has many defects such as arbitrage restrictions, some scholars believe that investors can not hold perfect portfolio, that is why a positive correlation exists between the two; in recent years, empirical studies even have shown that the two has negative correlation, namely the anomalies of "high risk earns low return". We try to figure it out by adding investor sentiment factor, which consists of two parts-the sentiment overall stock market and the sentiment on the stock. By analyzing all common stocks listing at the U.S. stock market from July 1965 to December 2007 with the method of sorting and empirical research, the results prove that the relationship between the two is not consistent when investor sentiment is at high or low level. When investor sentiment is high, the two are negative related; when investor sentiment is low, they are unrelated. Considering the different sample period, the different methods of calculation of idiosyncratic risk, the conclusion remains the same. Thus investor sentiment affects the nature of the relationship between idiosyncratic risk and expected returns.