The Overall Effect And Cross - Sectional Effect Of Investor Sentiment On Stock Returns: An Empirical Study Of Hong Kong Stock Market

Whether investor sentiment systematically impacts stock prices and returns has always been a key topic of debate within financial academia. Most empirical studies of investor sentiment and stock returns appeared after 1980 and there have been an abundant literature by now. The empirical literature has extended the research scope from the US stock market to other major stock markets around the world. However, the Hong Kong stock market seems to be an exception, in the sense that it has not been covered by such research so far, which is odd when considering the status of the HK stock market in global investment. As China gradually opens its capital account and allow its residents to invest overseas, the HK stock market will become a major investment destination for Chinese investors. Understanding the relationship between investor sentiment and stock returns in the HK market will definitely provide guidance for mainland investors.The behavioral finance theory believes that investor sentiment will systematically impact stock prices due to limited arbitrage. Investor sentiment will have both aggregate effects and cross-sectional effects on stock returns. This paper measured investor sentiment by forming composite indices of investor sentiment level and investor sentiment change in the HK stock market which is based on five underlying proxies, including HKSE share turnover, the number of IPOs, equity fund raised by newly listed companies, put-call ratio and VIX index.Our main empirical findings show:1) Investor sentiment has aggregate effects on stock returns in the HK stock market. In the short term, a positive correlation exists between aggregate market returns and investor sentiment. In the mid-to-long term, a negative correlation exists between aggregate market returns and investor sentiment.2) Investor sentiment has cross-sectional effects on stock returns in the HK stock market. The nonparametric approach shows that returns of small stocks, young stocks and high volatility stocks are more sensitive to investor sentiment. The regression approach confirms that the cross-sectional effects on stock returns concerning size and volatility are significant.