Investor Sentiment And Its Effect On Stock Returns

With the People's Bank of China rate cuts, China's nominal interest rates below the inflation rate has been substantially entered the era of negative real interest rates. Inflation expectations and negative real interest rates drive more and more cash into stock market. Although our stock market has become the world's second largest market by market value, but is still an emerging market. All investors were struck by what rapid rise and rapid fall of the stock market in 2015 and the stock index triggered circuit breaker many times in early 2016.Some of the irrational fluctuations of the stock price of traditional financial theory framework didn't have a reasonable explanation. But behavioral finance theory provided a new perspective to interpret these visions, so this paper study the effect of investor sentiment on the Chinese stock market based on the perspective of behavioral finance.As we all know, the investor sentiment is objective existence but not directly observed, so it is a necessary problem for us to measure investor sentiment. First, the principal component analysis (PCA) based on Baker and Wurgler had been used to build an investor sentiment. Then this paper has some comparison with"Individual Investors Sentiment Index" issued by Guotai Junan Securities. Given the nature of the investor sentiment is not observed, the state space model had been used to build a new investor sentiment index, and we compared this new indicator with the one that was formed by the PCA method. Then the paper used the Fama-French three-factor model to explore the relationship between investor sentiment with different style stock index, the empirical results show that investor sentiment has no significant influence on the return of Cninfo Market index, but there is statistically significant influence on the return of Cninfo small cap. Next, the paper established the Fama-French three-factor model with varying-coefficient, to study the dynamic influence between investor sentiment and stock market returns, it is concluded that investor sentiment influence on stock market returns is gradually weakened with the improvement of China's stock market system and investor's professional level. Subsequent, A Markov regime switch model is exerted to verify whether the influence between the investor sentiment and stock return changes in different regimes. The empirical results show that investor sentiment in high fluctuation regime has a significant impact on stock market returns, and in the low fluctuation regime has no significant impact on stock market returns. Finally, the article further validated the robustness of the empirical results using new investor sentiment index.The innovation of the paper is that Fama-French three factor model with varying-co efficient had been used to study the dynamic influence between investor sentiment and stock market returns. Compared to static impact analysis, varying-coefficient model are much more careful to observe the effects of sentiment on the stock market.The high proportion individual investors and the absence of the arbitrage mechanism is the direct cause of the existence of wide stock index swings. With the research of investors' sentiment based on the behavioral finance theory framework, the securities regulators will gain a correct understanding of the impact on investor sentiment in the stock market, while the investors will understand the sentiment and market correctly with rational investment decision.