Portfolio diversification dynamics of individual investors: a new measure of investor sentiment

We build a new measure of investor sentiment only based on changes in diversi?cation levels of individual investors? portfolios. The dynamics of the number of different stocks in portfolios is modelized as a Markov chain. We measure investor sentiment as the area above the cumulative distribution of the steady-state equilibrium of diversi?cation levels. We apply this model to a large sample of more than 80000 individual investors over the period 1999-2006. We ?rst show that our index is signi?cantly correlated to the French consumer sentiment index, to the Baker and Wurgler sentiment indices and to the buy-sell imbalance index, despite the fact we use neither prices or returns on stocks nor transaction volumes or even the identi?cation of stocks bought or sold by the investors. Following the two-step methodology of Baker and Wurgler (2006), we show that our measure outperforms the others in predicting returns of a long-short portfolio based on size.