Investors' Judgments, Asset Pricing Factors and Sentiment

Published date01 March 2015
Date01 March 2015
InvestorsJudgments, Asset Pricing
Factors and Sentiment
Hersh Shefrin
Santa Clara University, Santa Clara, CA 95053, USA
This paper presents results based on new data showing that the relationships
involving investorsjudgments of risk and variables such as beta, size, and book-to-
market equity (B/M) have the same directional effects as those involving realised
returns. Moreover, the relationships involving risk are mediated by BakerWurgler
sentiment, with directional effects similar to those that have already been docu-
mented for realised returns. In this regard, Baker-Wurgler sentiment mediates the
time series of investorsjudgments of expected return and the cross-section of their
judgments about risk. The results are consistent with the position that investors
judgments of risk and return, both mediated by sentiment, inuence market prices.
Keywords: risk, sentiment, size, book-to-market, beta, representativeness, affect
JEL classification: D03, G10, G12
1. Introduction
In empirical work, risk premiums for equities are typically explained using linear factor
models, with the factors based on variables such as size and book-to-market equity (B/M).
Notably, there is little theoretical justication for the selection of the factors used in these
models. Indeed Fama and French (2004) describe them as brute force constructs.At the
same time, there is an elegant theory addressing how risk premiums reward investors for
bearing risk. This theory relates expected return to both mean-variance efcient portfolios
and to the covariance between returns and a pricing kernel. However, results from
empirical analyses based on this theory have generally been inferior to those based on
brute force constructs.
Alongside the absence of theory, a disagreement emerged in the academic community
as to whether the empirical factor structure reects fully rational prices or instead reects
I thank Torben Andersen, Malcolm Baker, Nilifur Caliskan, Joni Clark, Thorsten Hens,
Alex Potts, Meir Statman, Jeff Wurgler, Ben Walker and the research team at Dimensional
Fund Advisors, Alexandre Ziegler, Stefan Zeisberger, journal editor John Doukas, and an
anonymous referee for comments.
European Financial Management, Vol. 21, No. 2, 2015, 205227
doi: 10.1111/eufm.12059
© 2014 John Wiley & Sons Ltd
investorsbehavioural biases. In describing this debate, Fama and French (2004) argue
that it is not possible to distinguish between the two possibilities empirically. Part of the
reason for the lack of agreement among scholars is reliance on realised returns to
discriminate among explanations (Black, 1993). In this regard, the moments of realised
returns are ex post variables, which cannot be automatically equated with investorsex
ante judgments of risk and expected returns.
This paper uses new data to study the ex ante judgments investment professionals make
about the risk and returns of holding different stocks. The new data is based on surveys
that were collected over the fteen year period 1999 through 2014. The ndings indicate
that investorscollective judgments about risk and expected return display some of the
features in the rational pricing perspective emphasised by Fama and French (2004) and
some of the behavioural features in the behavioural perspective emphasised by Baker and
Wurgler (2006, 2007).
Fama and French (2004) admit that they have no compelling explanation for why size
and B/M should underlie systematic risk, and call their approach a brute forcetechnique.
Nevertheless, the evidence from the workshop data is strong and consistent that investors
judgments about risk are negatively correlated with size and positively correlated
with B/M.
The evidence from the workshop data shows that investorscollective judgments reect
Baker-Wurgler sentiment in both the time series and cross-section of stocks. In respect
to the time series, the data show that investorsjudgments of expected return are positively
related to Baker and Wurglers sentiment variable (SENT). In respect to the cross-section,
Baker and Wurgler (2006) report that sentiment mediates the relationship between
both size and realised returns, and B/M and realised returns. The evidence reported in this
paper shows that sentiment mediates investorsjudgments about these relationships as
Investorscollective judgments about the cross-section of expected returns are
consistently at odds with the cross-section of realised returns. The evidence reported here
supports arguments advanced in the past by Shefrin and Statman (1995, 2003) that the
majority of investors expect higher returns from large cap stocks than from small cap
stocks, and higher returns from growth stocks than from value stocks. In other words,
investors act as if they attempt to implement a Fama-French factor model, but in the course
of doing so reverse the signs of the coefcients. An analysis of the data strongly suggests
that the underlying reason for these patterns is that in practice, investors judge that risk and
return are negatively related.
The remainder of this paper is organised as follows. Section 2 describes the new data.
Section 3 discusses the cross-sectional properties of perceived risk, and the cross-
sectional properties of expected returns. Section 4 analyses the behavioural features
underlying the relationship between perceived risk and expected return. Section 5
describes the relationship between investorsjudgments and the Baker-Wurgler sentiment
index. Section 6 discusses the cross-sectional properties of the expected return series
derived from analyststarget prices. Section 7 relates the ndings in this paper to earlier
work based on the annual Fortune magazine reputation survey. Section 8 concludes.
2. Data
The workshop data are derived from surveys administered between 1999 and 2004 in
workshops for portfolio managers and analysts. The surveys elicited judgments about
© 2014 John Wiley & Sons Ltd
206 Hersh Shefrin

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