Unveiling investor sentiment, attention, and speed of price adjustment in Indian market

Despite classical finance theory emphasizing rational investor behavior, sentiment-driven irrationality often leads to price distortions. Although investor sentiment is not directly observable, identifying suitable proxies and understanding the effect of investor sentiment on asset prices is an important topic. This study investigates the impact of investor sentiment on the speed of adjustment in the Indian market, which is characterized by a high degree of market sentiment. We develop an investor sentiment index at the stock level using seven sentiment proxies. Our sample includes the constituents of the CNX Nifty index from January 2005 to December 2020, totaling 4130 observations. The findings indicate that investor sentiment negatively impacts the speed of price adjustment, supporting the proposition that noise trader risk increases during high sentiment, causing mispricing in the market. We also examine the role of investor attention in the speed of price adjustment. The results show that the negative effect of investor sentiment on the speed of adjustment would weaken during periods of high investor attention, implying that investor attention improves market efficiency as it abbreviates the negative effect of sentiment for the price adjustment measure. We also find that the returns of firms with a faster speed of adjustment lead to the returns of firms with a slower speed of adjustment and the market portfolio returns.