Investor Sentiment and the Cross-section of Stock Returns
Malcolm Baker, Harvard Business School
Jeffrey Wurgler, NYU

We examine how investor sentiment affects the cross-section of stock returns. Theory predicts that a broad wave of sentiment will disproportionately affect stocks whose valuations are highly subjective and are difficult to arbitrage. We test these predictions by examining how the cross-section of subsequent stock returns depends on beginning-of-period proxies for sentiment. We find that when investor sentiment is low, subsequent returns are relatively high on small stocks, very young stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme-growth stocks, and distressed stocks, suggesting that these categories were relatively underpriced ex ante. When sentiment is high, on the other hand, the patterns largely reverse, suggesting that the same categories were relatively overpriced ex ante.

This research provides aggregate measures of investor sentiment and shows how they have been correlated with cross-sectional returns. The results will interest our members who make investment decisions based on sentiment.