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Investor sentiment and stock return predictability: The power of ignorance

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  • Catherine D'Hondt
  • Patrick Roger

Abstract

Sentiment measures, based on the trading activity of retail investors, carry some predictive power of future market returns. In this paper, we use such a sentiment measure on two samples of approximately 25,000 individual investors, who differ in their choices when answering MiFID questionnaires, especially in terms of their appetite for information and professional recommendations. Our data covers 51 months from January 2008 to March 2012. We show that the sentiment of investors who disregard free information and professional advice is the best predictor of future returns on a long-short portfolio based on size. Our findings remain valid when controlling for investor characteristics like spoken language (French or Dutch), portfolio value and financial literacy. Our results bring evidence that sentiment is essentially driven by underdiversification and narrow framing by retail investors. When shared by many investors, sentiment can generate long-lived mispricing, which is, therefore, difficult to arbitrage.

Suggested Citation

  • Catherine D'Hondt & Patrick Roger, 2017. "Investor sentiment and stock return predictability: The power of ignorance," Finance, Presses universitaires de Grenoble, vol. 38(2), pages 7-37.
    • Handle: RePEc:cai:finpug:fina_382_0007
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    Citations

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    Cited by:

    1. Desagre, Christophe & D’Hondt, Catherine, 2021. "Googlization and retail trading activity," Journal of Behavioral and Experimental Finance, Elsevier, vol. 29(C).
    2. Nicolas Aubert & Niaz Kammoun & Yacine Bekrar, 2018. "Financial decisions of the financially literate," Finance, Presses universitaires de Grenoble, vol. 39(2), pages 43-91.
    3. Bellofatto, Anthony & Broihanne, Marie-Hélène & D'Hondt, Catherine, 2019. "Appetite for information and trading behavior," LIDAM Discussion Papers LFIN 2019002, Université catholique de Louvain, Louvain Finance (LFIN).
    4. D’Hondt, Catherine & Merli, Maxime & Roger, Tristan, 2022. "What drives retail portfolio exposure to ESG factors?," Finance Research Letters, Elsevier, vol. 46(PB).
    5. Christophe Desagre & Catherine D'Hondt, 2020. "Googlization and retail investors' trading activity," LIDAM Discussion Papers LFIN 2020004, Université catholique de Louvain, Louvain Finance (LFIN).
    6. D’Hondt, Catherine & McGowan, Richard & Roger, Patrick, 2021. "Trading leveraged Exchange-Traded products is hazardous to your wealth," The Quarterly Review of Economics and Finance, Elsevier, vol. 80(C), pages 287-302.
    7. D'Hondt, Catherine & Elhichou Elmaya, Younes & Petitjean, Mikael, 2020. "Retail Investing in Passive Exchange Traded Funds," LIDAM Discussion Papers LFIN 2020013, Université catholique de Louvain, Louvain Finance (LFIN).

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