Analysis Of The Influence Of Investor Sentiment On Correlation Between Idiosyncratic Risk And Expected Return

There has been extensive research on the connection between idiosyncratic risks and expected returns. Both domestic and foreign scholars formed the following three main perspectives:according to CAPM model, some scholars believe that rational investors would have various investment portfolios to disperse idiosyncratic volatility, so idiosyncratic volatility wouldn’t influence expected returns. Based on equilibrium theory, researchers found that investors bearing additional risks should be compensated by higher returns, so there is supposed to be a positive correlation between idiosyncratic risk and expected return. Some scholars have found a negative correlation between idiosyncratic risk and expected return, i.e. "high-risk low-yield" phenomena. However, financial anomalies couldn’t be explained reasonably in traditional finance theory. So scholars research the deeper connection on risk-return from perspective of investors. Behavior finance focus on investors sentiment, relevant research has been confirmed the impact of sentiment on risk-return. This article study the influence of investor sentiment on connection between idiosyncratic risk and return, not only the research content of investor sentiment is extended, and provides a new perspective to explain the interpretation of idiosyncratic volatility and expected return relationship between ambiguous.From the perspective of behavioral finance, this paper introduces an index of investor sentiment, and attempts to use different manifestations of investor sentiment to explore the connections between idiosyncratic risk and expected return in Chinese stock market. We analyzed transaction data of Chinese A-share stock market from January 1999 to December 2013, and adopted Fama-French model and EGARCH (1,1) model to construct idiosyncratic volatility, and select the closed-end fund discount, turnover, number of new accounts and consumer confidence to build sentiment index structure. By applying investment portfolio analysis and Fama-Macbeth two steps regression on idiosyncratic volatility and expected return, we found that: when investor sentiment is low, there is a negative correlation between idiosyncratic volatility and expected stock return; while investor sentiment is relatively higher, there is a positive correlation between the two. In addition, considering that the difference of market effectiveness and investors’ irrational after non-tradable shares reform. We chose year 2005 (reform of non-tradable share of China stock market) as the dividing point. The new results both after and before 2005 still support the above conclusion, which means that investor sentiment has indeed influenced the connection between the idiosyncratic risks and expected stock return in China A-share market.Irrational behavior exists in many cases in Chinese stock market thanks to the pervasive irrationality of investors and the strong inclination to speculate. We suggest the Chinese government should strengthen the stock market regulation, improve the system of market and legislation, help investors form rational investment philosophy, and promote investors understand market risk and return rationally. We believe this will improve efficiency of investors’ decision-making, strength the market effectiveness.