Measures of Investor Sentiment: Who Wins the Horse Race?

Traditional research on asset pricing has focused on firm-specific and economywide factors that affect asset prices. Recently, the finance literature has turned to noneconomic factors such as investor sentiment as possible determinants of asset prices. Some researchers (e.g., Eichengreen and Mody, 1998) suggest that a change in one set of asset prices may change investor sentiment, thus triggering changes in a seemingly unrelated set of asset prices, especially in the short run, giving rise to pure contagion. Fisher and Statman (2000) and Baker and Wurgler (2006) have also recognized that investor sentiment may be an important component of the market pricing process. In fact, some studies (see, e.g., Baek, Bandopadhyaya and Du 2005) suggest that shifts in investor sentiment may explain short-term movements in asset prices better than any other set of fundamental factors. As the volume of studies that use investor sentiment to understand shifts in asset prices grows, so does the variety of investor sentiment measures. Dennis and Mayhew (2002) have used the Put-Call Ratio, Randall, Suk and Tully (2003) utilize Net Cash Flow into Mutual Funds, Lashgari (2000) uses the Barron’s Confidence Index, Baker and Wurgler (2006) use the Issuance Percentage, Whaley (2000) uses the VIX-Investor Fear Gauge, and Kumar and Persaud (2002) employ the Risk Appetite Index (RAI). A more detailed list of studies that utilize these and other investor sentiment measures appears in Exhibit 1