Investor sentiment toward stocks
I discussed some aspects of behavioral finance recently at a seminar for the investment professionals of a large investment company. In preparation, I presented to half of them the names and industries of several dozen companies and asked them to rate the future return of the stock of each company on a 10-point scale ranging from low to high. I presented the same list of companies to the other half and asked them to rate the risk of each stock on the same scale.
Standard financial theory predicts a positive correlation between expected returns and risk. The theory predicts that stocks rated high in expected returns would be rated high in risk. Yet this is not what I have found. Instead, I found a negative correlation. The investment professionals rated some stocks high in expected returns and low in risk, while they rated other companies as low in expected returns but high in risk. The perceptions of theses investment professionals are identical to perceptions of individual investors, as I found in a study with Kenneth Fisher and Deniz Anginer.
The perception of a negative relation between expected returns and risk is likely due to the ‘affect heuristic,’ described by Paul Slovic and his colleagues. We know affect in the finance literature as sentiment, where we speak about positive affect as positive sentiment and about negative affect as negative sentiment. Company names elicit sentiment, positive or negative. The names Google and Apple elicit positive sentiment, which attracts investors, whereas the names of Citigroup and Bank of America elicit negative sentiment, which repels investors. Companies with relatively positive sentiment tend to be growth companies with characteristics such as relatively low book-to-market ratios and relatively high market capitalizations. Companies with relatively negative sentiment tend to be value companies. Yet investor perceptions are driven by sentiment rather than by consideration of characteristics.
Companies which elicit positive sentiment are admired companies. Companies which elicit negative sentiment are spurned companies. Fortune magazine surveys executives and analysts each year and classifies companies along the admired-spurned line. Stocks of the admired companies in the Fortune surveys yielded lower returns, on average, than stocks of spurned companies. Investors who want high returns are wise to buy stocks of spurned companies. But I would offer no such advice to investors who know that facts of returns yet tilt their portfolios toward stocks of admired companies because they enjoy their glow. Enjoy!
Slovic, Paul, Melissa Finucane, Ellen Peters and Donald G. MacGregor (2002). “The affect heuristic,” Heuristics and Biases, Gilovich, Griffin and Kahneman eds. New York: Cambridge University Press.
Statman, Meir, Kenneth Fisher and Deniz Anginer (2008). “Affect in behavioral asset-pricing model,“ Financial Analysts Journal, vol. 64, no. 2 (March/April): 20 – 29.
Statman, Meir, “Investor sentiment, stock characteristics, and returns,” forthcoming in the Journal of Portfolio Management.