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Sentiment Effect and Market Portfolio Inefficiency

Author

Listed:
  • Rudolf F. Klein

    (Department of Economics, West Virginia University)

  • K. Victor Chow

    (Department of Finance, West Virginia University)

Abstract

We apply Marginal Conditional Stochastic Dominance (MCSD) tests to returns on sentiment beta sorted portfolios and sentiment-arbitrage portfolios, constructed using the Baker and Wurgler (2007) index of sentiment levels. The theory of MCSD demonstrates that, if one (mutually exclusive) subset of a core portfolio dominates another, conditional on the return distribution of the core portfolio, then the core portfolio is inefficient for all utility-maximizing risk-averse investors. Based on returns on the U.S. equity market, we show that both positively and negatively sentiment sensitive stocks are conditionally and stochastically dominated by sentiment insensitive stocks. Moreover, we find dominance among sentiment-arbitrage portfolios, constructed with positively sensitive vs. insensitive, insensitive vs. negatively sensitive, and positively vs. negatively sensitive stocks. Therefore, we conclude that the market portfolio is stochastically inefficient.

Suggested Citation

  • Rudolf F. Klein & K. Victor Chow, 2010. "Sentiment Effect and Market Portfolio Inefficiency," Working Papers 10-08, Department of Economics, West Virginia University.
  • Handle: RePEc:wvu:wpaper:10-08
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    File URL: http://be.wvu.edu/phd_economics/pdf/10-08.pdf
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    References listed on IDEAS

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    Keywords

    Investor Sentiment; Market Portfolio Efficiency; Stochastic Dominance.;

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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