Investors' Judgments, Asset Pricing Factors and Sentiment

• DOI: http://doi.org/10.1111/eufm.12059
• Author: Hersh Shefrin
• Published date: 01 March 2015
• Date: 01 March 2015

Investors’Judgments, Asset Pricing

Factors and Sentiment

Hersh Shefrin

Santa Clara University, Santa Clara, CA 95053, USA

E-mail: hshefrin@scu.edu

Abstract

This paper presents results based on new data showing that the relationships

involving investors’judgments 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 Baker–Wurgler

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 investors’judgments 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, influence 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 justification 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 efficient 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 reflects fully rational prices or instead reflects

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, 205–227

doi: 10.1111/eufm.12059

© 2014 John Wiley & Sons Ltd

investors’behavioural 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 investors’ex

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 fifteen year period 1999 through 2014. The findings indicate

that investors’collective 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 force’technique.

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 investors’collective judgments reflect

Baker-Wurgler sentiment in both the time series and cross-section of stocks. In respect

to the time series, the data show that investors’judgments of expected return are positively

related to Baker and Wurgler’s 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 investors’judgments about these relationships as

well.

Investors’collective 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 coefficients. 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 investors’judgments and the Baker-Wurgler sentiment

index. Section 6 discusses the cross-sectional properties of the expected return series

derived from analysts’target prices. Section 7 relates the findings 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