Beyond Rational: Investor Sentiment and Risk Perceptions

Investors judge risk and returns on sentiment and behavioral patterns, not just the rationality of prices, research has found. 

(May 5, 2014) — Investors incorporate rational prices as well as behavioral notions about perceived risksome not in line with the Fama-French three factor modelin determining prices, according to a paper.

The researcher observed investors’ judgment of risk and expected returns in relation to stocks’ size and book-to-market ratios. Through a survey of portfolio managers and analysts on one-year return expectations, perceived risk, and corporate reputations, the research concluded a positive correlation between investors’ perception of risk and the Fama-French view.

Investors believed a greater risk for stocks with higher betas, of smaller companies, and with higher book-to-market values, according to author Hersh Shefrin of Leavey School of Business at Santa Clara University.

“In most but not all years, a majority of investment professionals’ judgments about risk conform to the Fama-French view… [although] Fama and French offer no justification for why size and book-to-market ratio should be the basis for two of the risk factors underlying their framework,” he wrote.

In an average year, about half of investors’ judgements about risk were in line with the Fama-French view in Shefrin’s data, “meaning that they judge that risk is positively correlated with beta, negatively correlated with size, and positively correlated with book-to-market.”

The author also noted that perceived risk acted as a major contributor to realized returns, although the factors used for judgment for risk played a smaller role. Instead, investors’ views on realized returns were more consistent with the Baker-Wurgler view that predictability patterns in realized returns are conditional on recent sentiment.

Data showed that 74% of investors believed that risk and size were negatively correlated following periods of positive sentiment, while 88% did so after negative sentiment.

“The magnitude of these correlations suggests that investors’ judgments of risk are closely associated with the cross-section of realized returns,” Shefrin said. “Their conditional dependence on sentiment suggests that prices are not fully rational, but reflect a behavioral component.”

Moreover, as only 10% of the investors in Shefrin’s sample identified with the Fama-French perspective of rationality, to state that prices are fully rational is to assert that 90% of investors have “no net impact on asset prices,” according to research.

“Making a case that prices are fully rational without having a well specified notion of risk is tenuous at best,” Shefrin said. “Doing so in the face of data about strong, persistent, systematic biases in investors’ judgments of risk and return over time is even more tenuous, especially when these biases are closely liked to sentiment-based predictability in realized returns that have been documented in the existing literature.”

Read the full paper here.

Related Content: Is RAPM the New CAPM?

«