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Review of Behavioural Finance
The effect of US individual investor sentiment on industry-specific stock returns and

volatility
Mustafa Sayim, Pamela D. Morris, Hamid Rahman,
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RBF
5,1
The effect of US individual
investor sentiment on
industry-specific stock
58 returns and volatility
Mustafa Sayim
Alliant School of Management, Alliant International University,
San Diego, CA, USA
Pamela D. Morris
School of Business and Management, Kaplan University,
Ft. Lauderdale, FL, USA, and
Hamid Rahman
Alliant School of Management, Alliant International University,
San Diego, CA, USA
Abstract
Purpose – This paper examines the effect of rational and irrational investor sentiment on the stock
return and volatility of US auto, finance, food, oil and utility industries.
Design/methodology/approach – The American Association of Individual Investors Index (AAII)
is used as a proxy for US individual investor sentiment. The US market fundamentals are regressed
on investor sentiment in order to capture the effect of macroeconomic risk factors on investor
sentiment. Then impulse response functions (IRFs) are generated from a VAR model to investigate the
effect of unanticipated movements in US investor sentiment on both industry-specific stock return
and volatility.
Findings – The results show a significant impact of investor sentiment on stock return and volatility
in all the industries. We find that the positive rational component of US individual investor sentiment
tends to increase the stock return in these industries. We also document that unanticipated increase in
the rational component of US individual investor sentiment has a significant negative impact only on
the industry volatilities of US auto and finance industries.
Research limitations/implications – The results are based only on the 1999 – 2010 US industry-
specific stock return and volatility data and are confined to these industries.
Practical implications – The findings of this paper can help investors to improve their asset return
generating models by incorporating investor sentiment. The findings can also help policymakers to
design policies that stabilize sentiment and reduce volatility and uncertainty in the stock markets.
Originality/value – This paper adds to the growing literature on behavioral finance by filling a gap
and addressing the impact of investor sentiment in the various US industries.
Keywords Investor sentiment, Stock returns-volatility, VAR estimation, Investors, Stock returns
Paper type Research paper
1. Introduction
Deviations of stock prices from their fundamentals are widely documented in the
financial empirical literature (e.g. Shiller et al., 1996; Becchetti et al., 2007; Anderson
Review of Behavioral Finance
Vol. 5 No. 1, 2013
et al., 2003). Shiller’s et al., (1996) seminal paper cemented a belief in some form of
pp. 58-76 “market irrationality.” The failure of traditional financial models to explain unusual
r Emerald Group Publishing Limited
1940-5979
market phenomena like bubbles and crashes, and their general poor performance in
DOI 10.1108/RBF-01-2013-0006 predicting asset returns has led to the development of an impressive array of
behavioral models to show, among other things, that investor sentiment has an impact Investor
on stock prices. The premise of behavioral finance is that traditional finance ignores sentiment and
how investors make investment decisions (De Long et al., 1990). Hence behavioral
models focus on investors’ behavior and their investment decision-making process stock returns
(Barberis and Thaler, 2003).
A partial list of these models include Kyle (1985), De Long et al. (1990), Campbell
and Kyle (1993), Hirshleifer et al. (2006), Dumas et al. (2006) and Kogan et al. (2006). 59
However, attempts to empirically validate these models have produced mixed

results. Lee et al. (1991), Swaminathan (1996) and Neal and Wheatley (1998) find
investor sentiment significantly related to asset returns. Sias et al. (2001) do not
find a significant relation between proxies for individual investor sentiment and
closed-end fund discounts. Their results indicate that investors who hold closed-end
funds do not earn an additional risk premium for shouldering the noise trader risk.
Sentiment, unlike rational choice is society and culture specific. Thus, the results of
behavioral models are not necessarily applicable to different industry stock returns
and volatility, each one of which must be studied independently to determine the
relevance and applicability of the behavioral models in stock markets.
This paper examines the impact of US individual investor sentiment on stock
returns and volatility in the US auto, finance, food, oil and utility industry stock
returns and volatility. By examining the effect of investor sentiment on the
desegregated components of the market, i.e. by various industries, this paper fills a gap
in the existing literature and adds to the growing literature on behavioral finance.
The rest of the paper is organized as follows. Section 2 presents literature review,
Section 3 discusses the model and methodology, Section 4 presents data, Section 5 first
discusses the impact of US market fundamentals on sentiments, and then reports the
Vector Autoregression (VAR) results, and finally, Section 6 concludes the research.
2. Literature review
In the last two decades, the effect of investor sentiment on stock markets has been
extensively examined in finance literature. Some of the notable papers in which the
theoretical foundation of investor sentiment effect on stock returns have been
developed are Black (1986), De Long et al. (1990), Shleifer and Vishny (1997), Lewellen
et al. (1977), Poterba and Summers (1988), Lee et al. (1991), Elton et al. (1998), Campbell
and Shiller (1988), D’Avolio (2002), Trueman (1988), Barberis et al. (1998), Shefrin and
Statman (1994), Shleifer and Summers (1990), and Brown and Cliff (2004, 2005).
Previous studies reveal that investor sentiment has a significant effect on stock
returns, and has important implications for portfolio allocation and asset management.
The studies also reveal that investors act not only on rational sentiment but also on
irrational sentiment or noises. They may make investment decisions acting on their
beliefs even when there is no rational basis for the belief. Because of these sensitivities,
unexpected changes in the investor sentiment can have a significant effect on stock
returns (Baker and Wurgler, 2006, 2007; Barberis et al., 1998; Black, 1986; De Long
et al., 1990; Fisher and Statman, 2000; Kumar and Lee, 2006; Trueman, 1988).
Earlier studies have mostly focussed on investor sentiment and aggregate returns in
stock markets. The major focus of these studies was to test whether the stock market
as a whole can deviate from fundamental prices.
Shiller et al. (1996) investigate why the Japanese stock market crashed and lost
considerable value between 1989 and 1992. They found Japanese expectations for
future earnings growth in Japan became less optimistic between 1989 and 1994 and
RBF they concluded that the Japanese stock market crashed due to changes in Japanese
5,1 price expectations and speculative strategies.
Brown and Cliff (2004) investigate the effect of investor sentiment on near-term
stock in the US stock market. They show that historical stock returns are an important
variable for investor sentiment.
Baker and Wurgler (2006) find that investor sentiment has significant
60 cross-sectional effect in the US stock market. For example, they document that when
investor sentiment is low, subsequent stock returns are relatively high on small stocks,
young stocks, high-volatility stocks, unprofitable stocks, non-dividend-paying
stocks, extreme-growth stocks, and distressed stocks. This suggests that those
stocks are relatively underpriced in low-sentiment states. In the case of high-sentiment
states, they find the opposite pattern, indicating that these categories of stocks are
relatively overpriced.
Another study conducted by Kumar and Lee (2006) examines the impact of 1.8
million retail transactions on stock returns in the USA from 1991 to 1996. They test
the noise trader model, claiming that individual investor sentiment can have an impact
on stock returns. Their findings are consistent with noise trader theory and indicate
that systematic retail transaction activities have incremental explanatory power for
small stocks, value stocks, stocks with low institutional ownership, and stocks with
lower prices. Therefore, their results support the notion that investor sentiment has
an important impact on stock prices. Lemmon and Portniaguina (2006) examine the
effect of investor sentiment in the US stock market returns. They use data on consumer
confidence as a sentiment measure and conclude that consumer confidence predicts
time variation in stock returns. Their findings are consistent with the behavioral
finance theory that investor sentiment affects stock returns. In addition, they find that
when consumer confidence is high, investors appear to overprice small-cap stocks
relative to the large-cap stocks.
Most of these earlier studies on investor sentiment focus on aggregate returns in
stock markets. The effect of US individual investor sentiments on various industry
stock returns and volatility has not been fully examined. This paper fills this gap by
examining the impact of US individual investor sentiment on the stock return
and volatility of US auto, finance, food, oil and utility industries. Our results show
that the US individual investor sentiment has a statistically significant impact on
these industries.
Investor sentiment is a difficult construct to measure directly; therefore, all recent
studies on the subject use proxies. A commonly used proxy for individual investor
sentiment is the American Association of Individual Investors Index (AAII). This
proxy has been used by Brown and Cliff (2004), Clarke and Statman (1998), Lee et al.
(2002), Solt and Statman (1988), Verma and Soydemir (2006) and Calafiore (2010),
among others. We use the same proxy for US individual investor sentiment.
3. Research model and methodology

We employ an approach for measuring individual investor sentiment in the USA
that is similar to the methodology used by Qiu and Welch (2006), Verma and Soydemir
(2006) and Calafiore (2010). Investor sentiment proxies are likely to contain some
components of both rational and irrational investor sentiments (Brown and Cliff, 2004,
2005). The rational component of the sentiment is the part that is driven by economic
fundamentals while the irrational component is the part that is unexplained
by fundamentals. We follow Qiu and Welch (2006), Baker and Wurgler (2006),
Lemmon and Portniaguna (2006), Verma and Soydemir (2006), and Schmeling (2009) in Investor
the method for extracting the rational and irrational components of investor sentiment. sentiment and
The US macroeconomic variables are first regressed on investor sentiment in order
to capture the impact of economic risk factors on investor sentiment: stock returns
X
n
Sent1t ¼ g0 þ gj FUNDjt þ xt ð1Þ
j¼1 61
where Sent1t represents movements in the US investor sentiment at time t; g0 is

constant; gj is the set of n parameter to be estimated; FUNDjt is the set of n
macroeconomic variables representing investor expectations on risk factors; and xt is
the random error term. The random error term (xt) in the equation captures the
investor sentiment. The fitted value of Equation (1) captures the rational component of
sentiment (e.g. Sent̂1t). The residual of Equation (1) captures the irrational components
(e.g. xt).
Next we examine how the rational and irrational components of investor sentiment
affect various industry stock returns. Following Calafiore (2010), we model the return
generating process as in the following equation:
Rt ¼ a0 þ a1 Sent^1tk þ a2 xt þ a3 st þ pt ð2Þ
Where Rt is the industry stock return, a0 is constant, a1, a2, and a3 are the parameters
to be estimated, k is the appropriate lag length, and pt is the random error term. The
parameter a1 captures the impact of rational investor sentiment on industry stock
return, a2 captures the effect of irrational investor sentiment on stock return, and a3
captures the monthly volatility of the relevant US industry.
Finally, this paper examines how the US individual investor sentiment affects the
volatility of various industry returns. We use the standard deviation of the past
month’s continuously compounded returns to measure the volatility of the industry
returns. The continuously compounded monthly returns for each industry are
estimated using the following formula (Hull, 2007):
si
ui ¼ ln ð3Þ
si 1
where ui is the continuously compounding return between the end of the month i and
month i-1. Si is the value of the market variable at the end of month i. An unbiased
estimate of the standard deviation rate per month, s is calculated using the most recent
m observations on the ut. The following equation is then applied in order to examine
the impact of investor sentiments on the volatility of the various US industries
(Hull, 2007):
pffiffiffiffiffiffiffiffiffi X
m
st ¼ 1=m u2ti ð4Þ
i¼1
The sentiment variable computed using Equation (1) are then used as independent
variables to study their impact on industry volatility by setting up the model in
Equation (5) (Calafiore, 2010):
st ¼ a0 þ a1 Sent^1tk þ a2 xt þ pt ð5Þ
RBF where st is the one-month volatility of the industry as estimated in Equation (4); a0 is
5,1 constant, a1 is the parameter to be estimated, k is the appropriate lag length, a2 is the
coefficient of the irrational sentiment and pt is the random error term. The parameter a1
captures the effect of rational sentiment induced volatility, while a2 captures the effect
of irrational sentiment induced volatility.
The VAR modeling approach proposed by Sims (1980) is used to examine the
62 impact of US individual investor sentiment on industry return and volatility in
the USA. The predictive performance of VAR models is better than the more complex
structural models because VAR captures dynamic relationships in a relatively
unconstrained way and provides a good approximation of the true data-generating
process (Litterman and Supel, 1983; Hakkio and Morris, 1984; Webb, 1999).
However, time delays in the transmission of information from market fundamentals
to asset prices may create lags in the observation of data regarding macroeconomic
factors and the reflection of this information into asset prices. To determine the proper
lag lengths, this paper uses the Akaike information criterion (AIC) and Schwarz
information criterion (SIC). The VAR model is expressed as follows:
X
k
Z ðtÞ ¼ C þ AðsÞZ ðt sÞ þ eðtÞ
s¼1
where Z(t) is a column vector of variables under consideration; C is the deterministic

sentiment comprised of a constant; A(s) is a matrix of coefficients; k is the lag length;
and e(t) is a vector of random error term.
The VAR models presented above are multifactor index models that investigate
the relationship between movements in the US individual investor sentiment and
industry stock return. However, a weakness of the models is that they do not capture
the effect of unanticipated changes in investor sentiment on stock market returns
(Verma and Soydemir, 2006). In addition, it is difficult to interpret the coefficients from
the regression models in a VAR system and individual VAR coefficient results are not
able to capture the full impact of an independent variable (Statman et al., 2006).
Therefore, this paper additionally uses the generalized impulse response functions
(IRFs) generated from the VAR model to explore the effect of unexpected movements in
US individual investor sentiment on both stock return and volatility in US industries.
IRF traces the time path return and volatility response to exogenous unexpected
shocks to any one of the market fundamental variables and captures the dynamic
feedback effect in a relatively unrestricted way (Verma and Soydemir, 2006).
4. Data
The sample period for this paper on the impact of US individual investor sentiment
on the various industry stock returns and volatility extends from January 1999 to
December 2010. Following previous researchers, we use the AAII as the individual
investor sentiment proxy (Brown and Cliff, 2004; Fisher and Statman, 2000, Verma and
Soydemir, 2006). Individual investors do not participate in daily trading activities
to make a living; therefore, they seem to be less sophisticated traders or noise investors
(Baker and Wurgler, 2006).
AAII has been conducting a weekly survey asking its members for the likely
direction of the stock market during the next six months since July 1987. It has
approximately 1,00,000 members. The participants are randomly chosen among
members for each week’s survey. AAII then processes the results on a weekly basis and Investor
labels them bullish, bearish, or neutral. The individual sentiment index is computed sentiment and
as the Bull-Bear spread percentage. Since this survey reflects the expectations of
individual investors on the direction of the stock market, the index is an appropriate stock returns
proxy measure for individual investor sentiment. The survey index data are obtained
from AAII’s web site.
In addition, this paper uses several macroeconomic factors that are representative of 63
the US market fundamentals. The following are the most commonly used and accepted
variables in the asset pricing literature:
. economic growth measured as the monthly change in the US industrial
production index (IIP) (Fama, 1970);
. short-term interest rates measured as the yield on the one-month US Treasury
bill (Campbell, 1991);
. inflation measured as the monthly changes in the US consumer price index
(Fama and Schwert, 1977; Sharpe, 2002);
. currency fluctuations (Elton and Gruber, 1991) measured as the changes in the
US dollar exchange rate;
. business conditions measured as a default spread, which is the difference in
yields on Baa and Aaa corporate bonds (Fama and French, 1988);
. future economic expectation factors measured as the term spread, which is the
difference in yields on ten-year US Treasury bond and three-month T-bills
(Fama, 1990);
. excess return on the market portfolio measured as the value-weighted returns on
all NYSE, Amex, and NASDAQ stocks minus the one-month T-bill (Lintner,
1965; Sharpe, 1964);
. the premium on portfolio small stocks relative to large stocks (SMB) (Fama and
French, 1993);
. the premium on portfolio high-book-to-market stocks relative to small stocks
(HML) (Fama and French, 1993); and.
. the momentum factor, which is the average return on two high prior return
portfolios minus the average return on two low prior return portfolios
( Jegadeesh and Titman, 1993).
The data on the US IIP, business conditions, and inflation are obtained from
Datastream; short-term interest rates, the economic risk premium, future economic
variables, and currency fluctuations are obtained from the Federal Reserve Bank of
St. Louis; industry stock returns, the excess return on the market portfolio, SMB, HML,
and the momentum factor are obtained from the Kenneth French Data Library at the
Tuck School of Business, Dartmouth College.
5. Empirical results
Descriptive statistics of the USA
Table I summarizes the descriptive statistics of the variables used in this research
paper. The mean of SENT1 is 10.53 percent. This indicates that individuals have been
optimistic during most of the sample period. On the other hand, the measure of
RBF Mean Median Maximum Minimum SD Skewness Kurtosis
5,1
SENT1 0.10531 0.10965 0.50850 0.98300 0.18646 1.23913 9.65760
AUTO 0.00617 0.00345 0.49560 0.22880 0.08771 1.11477 8.65238
FIN 0.00269 0.00565 0.17050 0.21260 0.06156 0.40464 4.86571
FOOD 0.00575 0.01030 0.14930 0.11000 0.03939 0.19708 4.18931
64 OIL 0.01263 0.00980 0.19250 0.16970 0.06057 0.09494 3.56910
UTILITY 0.00618 0.01470 0.11760 0.12650 0.04736 0.67938 3.48342

BUSCON 0.01096 0.00920 0.03380 0.00550 0.00509 2.72458 10.77763
EXCRATE 0.00177 0.00099 0.06703 0.04673 0.01804 0.23510 3.79214
FUTEC 0.01570 0.01725 0.03350 0.00490 0.01097 0.19152 1.83323
HML 0.00324 0.00175 0.19720 0.20790 0.04807 0.16636 7.71618
IIP 0.00926 0.00917 0.01007 0.00855 0.00040 0.46986 2.16094
INF 0.02461 0.02600 0.05600 0.02100 0.01351 0.79669 4.36736
INT 0.02957 0.02535 0.06330 0.00230 0.01905 0.15083 1.67119
MOM 0.00315 0.00850 0.18390 0.34750 0.06527 1.36811 9.48010
RM 0.00161 0.00835 0.10170 0.17150 0.04839 0.54082 3.35342
SMB 0.00693 0.00495 0.14620 0.11600 0.03487 0.40753 5.08622
Notes: Variables are US individual investor sentiment (SENT1), monthly returns on US auto industry
(AUTO), monthly returns on US finance industry (FIN), monthly returns on US food industry (FOOD),
monthly returns on US oil industry (OIL), monthly returns on US utility industry (UTILITY), US
economic growth (IIP), US business conditions (BUSCON), US future economic conditions (FUTEC),
the premium on a portfolio of high book/market stocks relative to low book/market stocks (HML), the
Table I. premium on a portfolio of small stocks relative to large stocks (SMB), inflation (INF), short-term
Descriptive statistics interest rates (INT), momentum factors (MOM), currency fluctuations (EXCRATE), and excess return
of the US variables on the market portfolio (RM)
sentiment has a higher standard deviation than the various industry returns and
market fundamentals, suggesting that sentiment has been highly volatile during
this period.
The mean average return for the oil, auto, and the utility industries are 1.27, 0.0617,
and 0.618 percent, respectively, indicating that overall these industries have provided
a higher return than the finance and the food industries with 0.00269 and 0.00575
percent mean average returns, respectively. However, the auto, finance and oil
industries show higher volatilities than the utility and the food industries. Most of the
market fundamental variables have provided less volatility compared to the US
individual investor sentiment and the industry stock return.
The variance inflation factor (VIF) is calculated for assessing multicollinearity for
each independent variable in Equation (1). Table II shows VIF values for each
independent variable in the model. The VIF values in Table II are less than 5 which
indicates that each variable represents a distinctive characteristics of US
macroeconomic factors and that multicollinearity will not bias the results.
Table III reports the cross-correlations between US market fundamentals.
Estimation results
We first performed the Augmented Dickey-Fuller (ADF) Test (Dickey and Fuller, 1979,
1981) to check for the existence of a unit root in the time series of each variable. The
ADF Test suggests that the null hypothesis of non-stationarity is rejected for the first
difference of the time series for each variable, i.e. the series are stationary after
first differencing[1].
The study first examines the effect of market fundamental variables on US Investor
individual investor sentiment based on Equation (1). Table IV reports that the US sentiment and
individual investor sentiment is negatively related to US business condition (BUSCON)
and the excess return on the market (RM). However, the low value of Durbin-Watson stock returns
statistic (1.4018) in the regression indicates a high degree of positive first-order
correlation. In addition, the Jarqua-Bera histogram-normality test indicates a violation
of the normality condition, possibly caused by outliers[2]. 65
To remove the serial correlation in error term and to achieve normality in residuals,
an AR(1) process is included in Equation (1). The result shows that there is no serial
correlation problem with the revised model and the lagged residual is insignificant.
The Jarqua-Bera histogram-normality test shows that normality is also achieved after
the AR(1) process is included. (See footnote 2)
The results are reported in Table V. The Durbin-Watson statistic improves from
1.4081 to 1.9898, showing that there is no first-order serial correlation in error terms.
The findings in Table V reveal that US individual investor sentiment is significantly
negatively related to US business conditions (BUSCON) and the excess return on
the market (RM) but significantly positively related to US future economic
conditions (FUTEC), the premium on a portfolio of high-book/market stocks relative
The equation to calculate VIF scalar VIF independent variable ¼ 1/ ð1 Equation ð1Þ at R2 Þ
BUSCON EXCRATE FUTEC HML IIP INF INT MOM RM SML
VIF 1.95 1.14 1.86 3.39 1.59 2.15 1.63 3.25 1.53 1.27
Notes: Variables are variance inflation factor (VIF), US economic growth (IIP), US business conditions
(BUSCON), US future economic conditions (FUTEC), the premium on a portfolio of high book/market Table II.
stocks relative to low book/market stocks (HML), the premium on a portfolio of small stocks relative The variance inflation
to large stocks (SMB), inflation (INF), short-term interest rates (INT), momentum factors (MOM), factor of US market
currency fluctuations (EXCRATE), and excess return on the market portfolio (RM) fundamentals
BUSCON EXCRATE FUTEC HML IIP INF INT MOM RM SMB
BUSCON 1.00
EXCRATE 0.15 1.00
FUTEC 0.33 0.05 1.00
HML 0.02 0.05 0.00 1.00
IIP 0.21 0.03 0.58 0.12 1.00
INF 0.47 0.11 0.47 0.06 0.56 1.00
INT 0.51 0.12 0.82 0.06 0.30 0.49 1.00
MOM 0.23 0.05 0.04 0.74 0.13 0.21 0.16 1.00
RM 0.10 0.06 0.05 0.09 0.07 0.20 0.07 0.35 1.00
SMB 0.02 0.02 0.14 0.17 0.15 0.08 0.11 0.04 0.30 1.00
Notes: Variables are US economic growth (IIP), US business conditions (BUSCON), US future
economic conditions (FUTEC), the premium on a portfolio of high book/market stocks relative to low
book/market stocks (HML), the premium on a portfolio of small stocks relative to large stocks (SMB), Table III.
inflation (INF), short-term interest rates (INT), momentum factors (MOM), currency fluctuations Cross-correlations of US
(EXCRATE), and excess return on the market portfolio (RM) market fundamentals
RBF Sent1t ¼ g0 þ
Pn
þ xt
j¼1 gj FUNDjt
5,1 Dependent variable: SENT1
Variables Coefficient SE t-statistic Probability
C 0.827280 0.234826 3.522947 0.0006

BUSCON 0.209901 0.054132 3.877589 0.0002***
66 EXCRATE 0.851896 0.854549 0.996896 0.3207
FUTEC 1.844114 0.507665 3.632539 0.0004***

IIP 247.4158 249.8748 0.990159 0.3239
INT 20.63979 7.419195 2.781945 0.0062***
INF 1.566824 1.269832 1.233882 0.2195
MOM 0.736528 0.354546 2.077382 0.0397**
RM 1.190574 0.373993 3.183410 0.0018***
SML 0.832055 0.458800 1.813547 0.0720
HML 1.826939 0.533101 3.427002 0.0008***
R2 0.250249
Adjusted R2 0.193016
SE of regression 0.168094
Sum squared residuals 3.701474
Log likelihood 57.45455
F-statistic 4.372462
Durbin-Watson statistics 1.408185
Notes: Variables are US individual investor sentiments (SENT1), US economic growth (IIP), US
Table IV. business conditions (BUSCON), US future economic conditions (FUTEC), the premium on a portfolio of
The effects of US high book/market stocks relative to low book/market stocks (HML), the premium on a portfolio of
market fundamentals small stocks relative to large stocks (SMB), inflation (INF), short-term interest rates (INT), momentum
on US individual factors (MOM), currency fluctuations (EXCRATE), and excess return on the market portfolio (RM).
investor sentiment *,**,***Significant at 10, 5, and 1 percent levels, respectively
to low-book/market stocks (HML), the premium on a portfolio of small stocks relative

to large stocks (SMB), and short-term interest rates (INT). In other words,
the relationships between the independent variables (i.e. BUSCON and RM) and the
dependent variable (SENT1) are significantly negative suggesting that an increase
in perceptions on these variables (i.e. BUSCON and RM) have a negative impact on US
individual investor sentiment. The R2-value (0.3205) suggests that US market
fundamentals in the equation can explain about one-third of the variation in the US
individual investor sentiment. Overall, these findings provide evidence consistent
with previous literature that market fundamentals have an impact on investor
sentiment (Brown and Cliff, 2004, 2005; Qiu and Welch, 2006; Verma and Soydemir,
2006; Calafiore, 2010).
VAR estimation and IRFs

We use the regression model in Table V for the purpose of decomposing the US
individual investor sentiment variable into its rational and irrational components.
Next, we estimate the VAR model with two lags to investigate the impact of investor
sentiment found from Equation (1)[3].
The generalized IRFs derived from the VAR model is used to investigate the impact
of unexpected changes in the US individual investor sentiment on both the industry
return and volatility.
Sent1t ¼ g0 þ
Pn
þ ARð1Þ þ xt
Investor
j¼1 gj FUNDjt
Dependent variable: SENT1 sentiment and
Variable Coefficient SE t-statistic Probability stock returns
C 0.784717 0.294725 2.662542 0.0087
BUSCON 0.199691 0.067296 2.967345 0.0036***
EXCRATE 1.129684 0.844237 1.338113 0.1832 67
FUTEC 1.654788 0.495858 3.337226 0.0011***

IIP 230.9799 228.6532 1.010176 0.3143
INT 17.78786 7.888318 2.254962 0.0258**
INF 1.479739 1.589832 0.930752 0.3537
MOM 0.644091 0.327654 1.965768 0.0515*
RM 1.097397 0.346294 3.168979 0.0019***
SML 1.011913 0.410509 2.465023 0.0150**
HML 1.587037 0.575801 2.756227 0.0067***
AR(1) 0.315694 0.086761 3.638678 0.0004
R2 0.320576
Adjusted R2 0.262641
SE of regression 0.161233
Sum squared residuals 3.353481
Log likelihood 63.51232
F-statistic 5.533349
Durbin-Watson statistics 1.989867
Notes: Variables are US individual investor sentiments (SENT1), US economic growth (IIP), US
business conditions (BUSCON), US future economic conditions (FUTEC), the premium on a portfolio of Table V.
high book/market stocks relative to low book/market stocks (HML), the premium on a portfolio of The effects of US market
small stocks relative to large stocks (SMB), inflation (INF), short-term interest rates (INT), momentum fundamentals on US
factors (MOM), currency fluctuations (EXCRATE), and excess return on the market portfolio (RM). individual investor
*,**,***Significant at 10, 5, and 1 percent levels, respectively sentiment with AR(1)
Due to difficulties in interpreting the coefficients from the regression equations in VAR
systems, the IRFs are used to capture the full effect of unanticipated shocks to investor
sentiment (Sims, 1980; Statman et al., 2006). IRFs track the time series response
to unexpected changes in one variable while keeping the effects of other variables
constant. Confidence bands are built around the mean response using the Monte Carlo
method (Doan and Litterman, 1986). Responses are considered statistically significant
at 95 percent confidence level whenever the upper and lower confidence bands have
the same sign.
Figure 1 shows the impulse response of the US auto, finance, food and oil industry
stock returns to a one-time standard deviation increase in the US rational individual
investor sentiment. Consistent with the findings of previous studies’ (Brown and Cliff,
2004; Verma and Soydemir, 2006), Figure 1 a, b, c, d and e show, respectively, that there
is a significant positive impact of the US rational individual investor sentiment on the
US auto, finance, food, oil and utility industry stock returns. The responses are
significant in the first period on the US finance and utility industry stock returns,
though significance quickly disappears during the remaining periods. For example, in
Figure 1 b the first period impulse response indicates that one-standard deviation
shock to US investor sentiment results in approximately a 1.8 percent increase in the
US finance industry stock return.
RBF Response of the US auto to
the US individual investors
Response of the US finance to
5,1 0.12 0.08
0.06
0.08
0.04
0.04 0.02
68
0.00
0.00
–0.02
–0.04 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of the US food to Response of the US oil to

the US individual investors the US individual investors
0.06 0.08
0.06
0.04
0.04
0.02
0.02
0.00
0.00
–0.02 –0.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of the US utility to

0.06
0.04
0.02
0.00
–0.02
Figure 1. 1 2 3 4 5 6 7 8 9 10
Response of the US auto,
finance, food, oil and Note: The dashed lines on each graph represent the upper and lower 95 percent confidence
utility industry returns band. When the upper and lower bands carry the same sign, the response becomes
to US rational individual
investor sentiment statistically significant. On each graph, percentage returns are plotted on the vertical
axis, and time on the horizontal axis
Figure 2 presents the impulse response of the US auto, finance, food, oil and utility
industry return volatility to a one-standard deviation increase in the US rational
individual investor sentiment. The impulse response in Figure 2 a and b plots the time
path of US auto and finance industries’ volatility to a one-standard deviation increase
in the rational component of the US individual investor sentiment and shows the
significant negative relationship between investor sentiment and stock return
volatility. For example, the first period impulse response in Figure 2 a and b show that
Response of the US auto to
Response of the US finance to
Investor
6 0.08 sentiment and
0.06
stock returns
4
0.04
2 0.02
69
0.00
0
–0.02
–2 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

0.06 0.12
0.04 0.08
0.02 0.04
0.00 0.00
–0.02 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

0.12
0.08
0.04
0.00
–0.04
Figure 2.
1 2 3 4 5 6 7 8 9 10
Note: The dashed lines on each graph represent the upper and lower 95 percent confidence finance, food, oil and
band. When the upper and lower bands carry the same sign, the response becomes utility industry volatility
to US rational individual
statistically significant. On each graph, percentage returns are plotted on the vertical investor sentiment
a one-standard deviation shock to the US investor sentiment results in approximately

a 1 and a 0.2 percent decrease in the auto and finance industries’ volatility, respectively.
This might indicate that the US individual investors overall have an optimistic
expectation about the economy with respect to the US market fundamentals. This
positive expectation results in reducing uncertainty and the volatility of the US auto
and finance industry stocks returns. However, for the food, oil and utility industry,
RBF the response to changes in US rational individual investor sentiment is not significant
5,1 during the period (Figure 1 c, d and e, respectively).
Figures 3 and 4 plot the impulse response of the US auto, finance, food, oil and
utility industry returns and volatility to an increase in US irrational individual investor
sentiment. Figure 3 a and e present the impulse responses of the US auto and utility
70
Response of the US auto to Response of the US finance to

0.12 0.08
0.06
0.08
0.04
0.04 0.02
0.00
0.00
–0.02
–0.04 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

0.06
0.08
0.04 0.06
0.04
0.02
0.02
0.00
0.00
–0.02 –0.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

0.06
0.04
0.02
0.00
–0.02
Figure 3.
1 2 3 4 5 6 7 8 9 10
finance, food, oil and Note: The dashed lines on each graph represent the upper and lower 95 percent confidence
utility industry returns to
band. When the upper and lower bands carry the same sign, the response becomes
US irrational individual
investor sentiment statistically significant. On each graph, percentage returns are plotted on the vertical
Response of the US auto to
Response of the US finance to Investor
0.20 0.08 sentiment and
0.15 0.06 stock returns
0.10 0.04
0.05 0.02
71
0.00 0.00
–0.05 –0.02
–0.10 –0.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

0.05 0.20
0.15
0.04
0.10
0.02
0.05
0.00
0.00
–0.02 –0.05
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

0.20
0.15
0.10
0.05
0.00
–0.05
–0.10
1 2 3 4 5 6 7 8 9 10
Figure 4.
Note: The dashed lines on each graph represent the upper and lower 95 percent confidence finance, food, oil and
band. When the upper and lower bands carry the same sign, the response becomes utility industry volatility
to US irrational individual
statistically significant. On each graph, percentage returns are plotted on the vertical investor sentiment
industry returns to a one-standard deviation increase in the US irrational individual

investor sentiment. The responses are positive and significant in the first period for
the US auto industry and in the second period for the US utility industry return.
Consistent with the findings of previous studies, unexpected changes in the irrational
component of individual investor sentiment tends to increase the US auto and utility
industry stock returns (Calafiore, 2010).
RBF Figure 4 plots the impulse responses of the US auto, finance, food, oil and utility
5,1 industry volatility to a one-time standard deviation increase in the US irrational
component of investor sentiment. All the responses turn out to be statistically
insignificant. Our results do not find any evidence that a shock to the US irrational
individual investor sentiment causes any significant changes in the volatility of US
auto, finance, food, oil and utility industries. This finding is not consistent with the
72 findings of De Long et al., (1990) regarding noise or irrational investors who increase
market risk by not using the firm’s fundamentals when trading.

The empirical results of the generalized impulse functions generated from VAR
reveal that there is a significant positive impact of US rational individual investor
sentiment on the US auto, finance, food, oil and utility industry stock returns. The
responses are significant in the first period on the US finance and utility industry stock
returns, though significance quickly disappears during the remaining periods. For
example, the first period impulse response indicates that one-standard deviation shock
to the US investor sentiment results in approximately a 1.8 percent increase in the
US finance industry stock returns. In addition, the impulse response shows that a
one-standard deviation increase in the rational component of the US individual
investor sentiment has a negative significant effect on the US auto and finance
industries’ volatility. For example, the first period impulse responses indicate that a
one-standard deviation shock to the US investor sentiment results in approximately
a 1 and a 0.2 percent decrease in the auto and finance industries’ volatility, respectively.
Consistent with existing literature, a one-standard deviation increase in the US rational
individual investor sentiment reduces the US auto and finance industry volatility
(Brown and Cliff, 2004; Verma and Soydemir, 2006; Calafiore, 2010).
These results are important in that they show the US individual investor sentiment
is driven by both rational and irrational impulses. They also show the AAII is a good
proxy for investor sentiment.
6. Conclusion
This paper investigates the effect of both rational and irrational components of US
individual investor sentiment on the US auto, finance, food, oil and utility industries
stock returns and volatility. The existing literature has revealed that market
fundamentals significantly affect investor sentiment. Likewise, this paper provides
evidence that the US market fundamentals have an impact on the US individual
investor sentiment. The results reveal that individual investor sentiment is
significantly negatively related to the US business condition (BUSCON) and the
excess return on the market (RM) but significantly positively related to US future
economic conditions (FUTEC), the premium on a portfolio of high-book/market
stocks relative to low-book/market stocks (HML), the premium on a portfolio of small
stocks relative to large stocks (SMB), and short-term interest rates (INT). In other
words, the relationships between the independent variables (i.e. BUSCON and RM)
and the dependent variable (SENT1) are significantly negative suggesting that an
increase in perceptions on those variables (i.e. BUSCON and RM) have a negative
impact on the US individual investor sentiment. The R2-value (0.3205) suggests that US
market fundamentals in the equation can explain about one-third of the variation in
the US individual investor sentiment. Overall, these findings provide evidence
consistent with previous literature that market fundamentals have an impact on
investor sentiment (Brown and Cliff, 2004, 2005; Qiu and Welch, 2006; Verma and
Soydemir, 2006; Calafiore, 2010).
Consistent with the findings of previous studies (Brown and Cliff, 2004; Calafiore, Investor
2010; Verma and Soydemir, 2006), this paper shows that a one-standard deviation sentiment and
increase in the US rational and irrational investor sentiment has a significant positive
impact on the US auto, finance, food, oil and utility industry returns. This suggests stock returns
that a positive investor sentiment tends to increase the US industry returns.
The paper also documents that a one-standard deviation increase in the rational
component of US investor sentiment has a negative significant effect only on the US 73
auto and finance industry volatility. In other words, an unexpected increase in rational
sentiment reduces the volatility of US auto and finance industry. This might indicate
that investors have optimistic expectations of the economy overall with respect to
market fundamentals. Consistent with existing literature, this optimism can result in
creating positive expectations, reducing uncertainty, and reducing the volatility of
stock market returns (Brown and Cliff, 2004; Calafiore, 2010; Verma and Soydemir,
2006). Overall, the paper reveals that individual investor sentiment has an impact on
the stock returns and volatility making it systemic to financial market movements.
The statistical significance of US individual investor sentiment on the stock market
return and volatility found in this paper can help investors to improve their asset
valuation models by incorporating an investor sentiment variable into the return
generating process. Besides, the financial markets have always been a good indicator
of the economy overall. This research provides support for the impact of investor
sentiment on the return and volatility of various US industries and will therefore
help policymakers to design policies that stabilize sentiment and reduce volatility and
uncertainty in the stock markets.
An interesting extension of this research would be to study the impact of business
cycle stages on investor sentiment and to see how this translates into changes in
stock return and volatility for different industries. Prima facie one would expect that
investor sentiment changes brought on by different phases of the business cycle
will differentially impact the various industries with a more significant effect on
industries dealing with capital goods and luxuries, e.g. autos as compared to
industries dealing with necessities, e.g. food. This question, though intriguing, is left
for future research.
Notes
1. The results of unit root tests are available from the authors upon request.
2. Results of the the Jarqua-Bera histogram normality test are available from the authors upon
request.
3. The results of the VAR estimates are available from the authors upon request.
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Corresponding author
Mustafa Sayim can be contacted at: msayim2@alliant.edu
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Review of Behavioural Finance

The effect of US individual investor sentiment on industry-specific stock returns and

*Related content and download information correct at time of download.

However, attempts to empirically validate these models have produced mixed

3. Research model and methodology

where Sent1t represents movements in the US investor sentiment at time t; g0 is

where Z(t) is a column vector of variables under consideration; C is the deterministic

UTILITY 0.00618 0.01470 0.11760 0.12650 0.04736 0.67938 3.48342

BUSCON EXCRATE FUTEC HML IIP INF INT MOM RM SMB

C 0.827280 0.234826 3.522947 0.0006

FUTEC 1.844114 0.507665 3.632539 0.0004***

to low-book/market stocks (HML), the premium on a portfolio of small stocks relative

VAR estimation and IRFs

FUTEC 1.654788 0.495858 3.337226 0.0011***

Response of the US food to Response of the US oil to

Response of the US utility to

Response of the US food to Response of the US oil to

Response of the US utility to

a one-standard deviation shock to the US investor sentiment results in approximately

Response of the US auto to Response of the US finance to

Response of the US food to Response of the US oil to

Response of the US utility to

Response of the US food to Response of the US oil to

Response of the US utility to

industry returns to a one-standard deviation increase in the US irrational individual

market risk by not using the firm’s fundamentals when trading.

of Empirical Finance, Vol. 11 No. 4, pp. 1-27.

Saddle River, NJ.

Vol. 44 No. 5, pp. 45-55.

To purchase reprints of this article please e-mail: reprints@emeraldinsight.com

Analysis 32, 1-12. [Crossref]

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