King Saud University

College of Business Administration

Council of Graduate Programs in Business
Ph.D. Program in Business
(Finance Major)

Investors’ sentiment and the stock market behavior:

An empirical analysis of the Saudi stock market

A Proposal Submitted for the Degree of

Doctor of Philosophy in Business Administration
(Finance Major)

Student Name: Basmah Maziad Altuwaijri

Student Number: 431203555

Submitted:8/10/2016

Electronic copy available at: https://ssrn.com/abstract=2889708

 Abstract
Lately, investors’ sentiment has become one of the major concentrations of finance literature
on asset pricing model. Many research findings argued that changes in investors’ sentiment
measure could have an impact on stock returns and volatility and that investors’ sentiment
might be an essential variable in the investment decision making .The main purpose of this
dissertation is to explore investors’ sentiment as one area of behavioral finance that has not
been searched before in the Saudi stock market1. This research attempts to come closer at
discussing two highly important topics involving investors’ sentiment. Firstly, we will
investigate the impact of investors’ sentiment measured by an exclusive index that was
constructed for the purpose of this research using principal component approach and a
number of sentiment proxies such as the trading volume, and dividend premium on both stock
market return and volatility, taking into account some controlling variables the researcher has
found them very relevant in this area of investigation, such as liquidity and book-to-market
ratios. Secondly, this dissertation will study the relationship of investors’ sentiment and the
mispricing of the whole Saudi stock market.
This dissertation should have useful practical implication for investors, fund managers,
financial advisors and policy makers. It will give the investors a better understanding of many
aspects of their sentiment. It will also help fund managers and financial advisor to conduct
better price forecasting, and finally it is crucial for policy makers who should work on
stabilizing investor sentiment in order to decrease stock market volatility and uncertainty.

Key words: investors’ sentiment index , stock market return and volatility, consumer confidence index,
Trading volume, Stock market liquidity, stock market mispricing.

1
To the best of our knowledge, there are no previous studies establishing the connection between
investor sentiments and the Saudi stock market return, volatility and mispricing.

Electronic copy available at: https://ssrn.com/abstract=2889708

 Chapter 1

Introduction

Traditional finance theory seeks to comprehend investors’ financial decision making

by stating a number of assumptions, firstly, it assumes investors’ rationality, which
means that the majority of investors are making their investment decisions based on
their correct processing of any new available information and therefore, stock prices
reflect their fundamental values. (Barberis and Thaler, 2003, page 1053). Secondly, it
assumes that investors are avoiding risks, therefore if they take more risk, they expect
to be compensated by higher returns (see for example, Campbell, 1996; Ghysels et al,
2004) Finally, traditional finance theory assumes that investors undertake their
financial decisions in an unbiased matter that will lead to increase their self-interests.
Based on these rigorous assumptions, researchers came up with many theories and
models such as the theory of portfolio selection by Harry Markowitz, (1952), the
classical capital asset pricing model (CAPM) by William Sharp, (1965), the efficient
market hypothesis (EMH) by Eugene Fama (1970).

The traditional rational theories state that the underlying values of the stocks (intrinsic
values) are reflecting the present value of their future cash flows. Subsequently,
correlation between the returns of the two assets rising from their fundamental values
are impacted by the same risk factors which is the market beta as was indicated by
Sharp (1964), Linter (1965) and Black (1972) when they introduced and developed
the asset pricing model, which dominated the research area of risk return relationship
for a long period. However, recent studies that started in the early eighties of last
century show that stock returns exhibit strong correlation through time with no
common risk factors, instead, researchers pointed out other factors such as Banz
(1981) who showed the impact of size, Statman (1980) who discussed the positive
relationship between stock returns and the book value of the firm’s common stocks.

Therefore, the traditional theories fail to provide comprehensive understanding

regarding this phenomenon, and the need for another school of thinking was a bare
necessity.

On the other hand, a new strand of research called behavioral finance has emerged,
which argued that investors’ complete rationality is not accepted any more and there
are some cognitive biases that might explain their investment behavior. Behavioral
finance in fact relies on two basic ideas; limits to arbitrage and psychology that was
first introduce by (Shleifer and Summers, 1990), Psychology in specific deals with
investors’ irrationality and the existence of cognitive biases such as investors’
sentiment. The current academic research is driven by several behavioral theories
explaining the impact of investors’ sentiments on investment decisions and their
subsequent portfolio allocations. On this topic, (Simon, 1967; Loewenstien et al,
2001) show that there is a direct link between the emotional reactions of investors and

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their behaviors, and thus affecting their decision-making process. The most popular
research in the recent behavioral finance literature that investigated the relationship
between investors’ sentiment and stock market behavior was conducted by (Baker and
Wurgler, 2006). They constructed a sentiment index and used it to measure the impact
of sentiment on stock market return and volatility, their findings revealed that their
results challenged the traditional finance theories that ignored the role of investors’
sentiment in the cross-section of stock prices, they succeeded in proving that
investors’ sentiment has significantly impacted the cross­section of stock prices.
(Rehman, 2013) studies the influence of investors’ sentiment on the Karachi stock
market returns and volatility and concludes that sentiment plays a significant role in
the stock market behavior. (Huiwen, 2012) also tries to explore the relationship
between investors’ sentiment and finds that when investors misperceives the
securities prices, they tend to make these prices deviate from their fundamental
values. (Chi et al, 2012) find a strong relationship between investors’ sentiment and
stock market returns and volatility of the emerging market of China.

When investors trade on information that is not fundamental, they are called noise
traders or uninformed traders. The impact of the investment activities of these traders
on stock prices has been the ground for researchers’ debate for a long time. (De Long
et al, 1990) constructed a noise trader model and argued that these noise traders cause
securities' prices to move away from their original fundamental values. They also
argued that the impact of these noise traders is reduced tremendously when the
rational arbitrageurs step in to balance the noise traders’ irrational activities. These
arbitrageurs’ rational activities are also limited by the cost of arbitrage, which could
prevent them from stepping in more if it is high, and consequently cause the
securities' prices to move away from their fundamental values. In fact, the noise trade
model led to more researches that offer clear proof of the existence of investors'
sentiment and the relationship between investors' sentiment and the stock market
return, volatility and mispricing, see for example (Brown and Cliff, 2004)

A common finding in recent literature in the field of behavioral finance is that a

proportion of the return and volatility in stock markets is attributed to investors'
emotions and moods. For instance, (Wright and Bower, 1992) claimed in their
research that a direct link exists between stock prices and investors’ mood. In good
moods, investors are more optimistic in their investment decision-making process
than those who are in bad moods. (Yang and Wu, 2011) explored the relationship
between investors’ sentiment and stock price volatility in the Taiwanese stock market,
their findings showed that the influence of the different measures they used for
sentiment on volatility ranged from weak to strong. (In et al, 2010) tried to explain the
stock market mispricing in relation with cognitive biases by using “Fama­French
factors”, their results showed that the overreaction associated mispricing proposition
explain the impact of the volume but not the increased worth.

Many researchers around the world tried to investigate the relationship between

4
investors' sentiment and the stock market behavior by using different proxies to
measure sentiment, their results are mixed. For example, (Verma and Soydemir,
2006) examined the effect of investors' sentiment measured by survey data on
international stock market returns and found out that there was a significant influence
of investors' sentiment on market return. This influence differs from country to
country based in two factors: the country's trade relationship with the United states
and the institutional ownership. In the same fashion, (Schmeling, 2009) studies the
impact of investors' sentiment represented by the consumer confidence index on 18
countries stock market returns. His results show that the impact is negatively related
with institutional ownership and market integrity and positively related to investors'
herd behavior.

In a more recent paper, (Finter et al, 2011) constructed an investors' sentient index
and analyzed the impact of investors' sentiment represented by that index on the
German stock market, they concluded that sentiment has weak impact on the market
return and they attributed that result to the fact that the German stock market is
mainly consisted of institutional investors who are not affected by sentiment
fluctuation. In this regard, (Chi et al, 2012) used the mutual fund flow as a proxy for
investors' sentiment and study the impact of this proxy on the returns of the Chinese
stock market, their results show a positive relationship between investors' sentiment
and stock market return. They explained this result by indicating that the Chinese
stock market is an emerging market and investors are lacking the required experience.

(Kim and Park, 2015) investigate the relationship between investors' sentiment and
stock market return in the Korean stock market. They use the buy-sell imbalance of
daily trade activities as a proxy for sentiment and they conclude that sentiment has no
impact on stock returns.

Based on these mixed outcomes of previous researches, this study will shed some
light on the relationship between investors’ sentiment and the behavior of stock
markets in the Saudi stock market, which is a significant behavioral finance issue
discussed in the current finance literature. The focus of the study is to find out
whether or not the investors’ sentiments have an effect on the behavior of Saudi stock
market. In the case of the expected effect, the direction of the relationship between
investors’ sentiment and the stock market will be examined and reported. We expect
this relationship to be positive based on many facts that dominated the Saudi stock
market as an emerging market inhabited by the majority of individual investors and
not fully regulated by the capital market authority.

Since the study is mainly concerned with the Saudi stock market, it is very important
to provide some brief introduction about the market. The Saudi stock market is a
relatively new market when compared to other stock markets around the world. It
stayed unregulated till the year 1984, after that The Saudi Arabian Monetary Agency

5
(SAMA), the central bank of Saudi Arabia started supervising the stock trading
through the commercial banks, and later through the introduction of the electronic
security information system (ESIS) in 1990 in which all twelve banks at that time
were connected through this system with SAMA. The capital market authority was
established in July 2004 by royal decree (M/30) and became the only regulating body
of the capital market since then. The Saudi stock market witnessed a number of
important evolutions during the past decade, the number of listed companies has
increased from 70 in 2004 to more than 170 in 2016 which implies the market
strategy to encourage more privately and governmentally owned companies to go
public. Another major evolution is the market liberalization that occurred on June
2015 and gave the qualified foreign investors (QFI) the right to trade directly in the
market.
The Saudi stock market is consisted of 15 sectors, banks and petrochemical sectors
are the dominant ones, and they represent 51.6% of the total market capitalization in
2014. Trading activities in the Saudi stock market is dominated by retail investors
who account for 86.9% of the total trades versus 11.8% for the investment institution
and 1.2% for the foreigner in 2014 (SAMA financial stability report, 2015).
The behavioral finance aspects have been the focus of many studies carried out in
many stock markets across the globe. However, these aspects have not received
enough attention from scholars in the Arabian Gulf region in general and in Saudi
Arabia specifically. We found a few studies that dealt with behavior of the Saudi
stock exchange (SSE) in relation to other factors other than investors’ sentiment.
Examples include a study conducted by (Cheng et al, 2009) who study nine Middle
Eastern and North African countries, among those countries are four Gulf countries:
Bahrain, Kuwait, Oman and Saudi Arabia. The study tried to determine the degree of
integration of these stock markets with the world financial markets, and the time
variation of these markets to integrate with the world financial markets. The study
also investigated the risk-return trade-off in these markets. They concluded that the
Saudi stock market is not integrated with the rest of the world financial market and
they found evidence in favor of a positive risk-return trade-off in Saudi Arabia
(Cheng et al, 2009, page 426).
Another research by (Alsuhaibani and Kryzanowski, 2001) analyzed the Saudi stock
market trading by using limit versus market orders and the subsequent profitability as
a result of this choice. They used logit model and found that limit order trading

6
strategies outperform market order trading strategies (Alsuhaibani and Kryzanowski,
2001, page 23). However, the focus of this study is different from other researchers
that study the Saudi stock market. Our study is concentrating on investigating the
relationship between investors’ sentiment and the Saudi stock return, volatility and
mispricing.

Given the fact that retail investors represent more than 85% of total investors in Saudi
stock market and the actual behavior of the stock market retail investors differs from
their attitude toward investment. They, in fact, take into account a number of factors
when they make their investment decisions, such as their investment goals, needs and
limits, however, it is not feasible that investors are always making the right
investment decisions. The reason for that is the various factors that has an impact on
their attitude such as the dividend distribution, stories of other successful investors,
the desire to become rich, and so on (see, Al-Tamimi, 2006).
The understanding of those investor behavioral attitudes is very essential for financial
advisors and planners, understanding how investors react to the stock market
movements might assist the financial advisors in selecting suitable investing strategies
for their clients. This in fact was our first motivation to study this important topic.
This research was secondly motivated by the fact that the literature of behavioral
finance is encumbered with hundreds of articles related to investors’ sentiment in
many parts of the world. However, no comprehensive study of investors’ sentiment
was conducted in Saudi Arabia. Although there are a few attempts to study the
connection of some calendar anomalies such as hajj and Ramadan to the investors’
sentiments. Examples are (Abbes and Zouch, 2015; Alkhazali, 2014; Bialkowski et al,
2012).
The third motivation that led the researcher to investigate the relationship between the
investors’ sentiment and the stock market behavior is the unexplainable valuation of
some if not the majority of the Saudi listed stocks before the crash of 2006 which
results in the sharp decrease of the Saudi index (TASI) from over 20,000 points
(20,634.86 on February 25th, 2006) to nearly 7000 points by the end of 2006. The
stock market lost 65% of its value for the first time since its establishment in 1985
(Tadawul annual report, 2006, page 3). Most listed stocks at that time were
overvalued and their market prices doesn’t reflect their fundamentals, the researcher
assumes that the reasons for that unreasonable and unexplainable overvaluation of the

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stock market is due to some behavioral factors associated with the increased demand
by investors who enter the market with a limited amount of knowledge and
experience. In fact the choice of the study period (2003-2015) was intentional to
capture the stock market behavior during this major crash of 2006 and less intensive
crash of 2008. Some researchers tried to explain what happened in the Saudi stock
market in 2006, (Alkhaldi, 2015) relate the crises of 2006 to the weakness of stock
market infrastructure that was not sufficient for the market and investors’
development. (Altuwaijri, 2007) has attributed the 2006 Saudi stock markets to three
factors: the government that didn’t effectively regulate the stock market; the media
that played a negative part by not explaining the downsides of investing in stock
markets; and finally the investors who didn’t bother to educate themselves about
stock market investing before entering the market and who borrowed heavily or
liquidate their assets in order to invest in stock markets.
The fourth motivation of this research is the numerous changes that the Saudi stock
market is witnessing in its recent development. The expansion of the market and the
increased number of initial public offerings (IPOs) including the partial IPO of
ARAMCO as part of the new 2030 vision of the Saudi government is one example of
these developments. The new regulations announced by TADAWUL and the Capital
Market Authority (CMA) in relation to market settlement and Qualified Foreigner
Investors (QFI) is another example of the Saudi stock market development that will
increase the market depth and level of liquidity. These developments among other
factors will have its impact on the stock market behavior and will be considered by
the researcher as control variables.
In light of the foregone arguments related to the motivation and the relevance of
investor sentiment as a systematic risk factor which is priced into the markets, the
main purpose of this research (dissertation) provides a comprehensive understanding
of investors’ sentiment in the Saudi stock market as an important component of
behavioral finance and investigate the role of investor sentiment in the stock market
behavior. Specifically, we research 1) the impact of the investor sentiment on stock
return and volatility and 2) the association between investor sentiment and stock
market mispricing.

We believe, from the above arguments that the study is significant from different
aspects. The study will contribute to the literature of investors’ sentiment by 1)

8
providing an insight of the topic in the Saudi stock market, 2) the study will also
construct an investors’ sentiment index for the Saudi market that could be utilized in
future related research, 3) the study will cover the period of 2003-2015 and therefore
will provide some insight to the relationship between investors’ sentiment and the
financial crisis of 2006 and 2008. This research is important specifically to financial
advisors and fund managers who always attempt to forecast security returns. It will
attract their attention to the significance of investor sentiment in predicting stock
market returns. This research is also important for policy makers who should work on
stabilizing investor sentiment in order to decrease stock market volatility. This
research is also significant for portfolio managers who should take their investors’
sentiment into account when assessing stocks and hedging risks.
Given the fact that in today’s highly volatile stock markets, there is no common asset-
pricing model that can assist investors to correctly price the risky assets and make the
right investment decision, they should not limit themselves to the fundamental and
should relate their decisions to their subjective expectations of future stock prices. In
other terms, they should understand their cognitive biases, more precisely, their
sentiment, which is the main focus of this research and the factor that will be tested as
one of the determinant of stock market returns.

The main drive of this study is to investigate the effect of investors’ sentiment on the
Saudi market returns, volatility and mispricing during the period 2003-2015. The
choice of this specific period is due to the aim of the researcher to capture most of the
important extreme events of the Saudi stock exchange such as the financial crises of
2006 and 2008. In the literature of investors’ sentiment, a number of proxies to
measure investors’ sentiment are found (see among others, Baker and Wurgler, 2012).
These measures are explained in great details in a later section of this research. For
the purpose of this research, we will combine four measures to construct an investors’
sentiment index, these measures are: the stock market liquidity measured by the
trading volume, the Number of IPO during the study period, the average first-day
return on IPO during the study period and the dividend premium that is computed as
the difference between market to book value ratio of dividend-paying and non
dividend-paying securities. The selection of these four measures was mainly inspired
by the availability of data and their ability to represent different aspects of investors’
sentiment in various studies around the world. Their ability to do so is yet to be

9
proven in the Saudi stock market. Other measures such as consumer confidence index
(CCI) provided by the Nelson company will be used in robustness check for the sub-
period 2010-2015 as in (Verma and Soydemir, 2006; Qiu and Welch, 2004; Brown
and Cliff, 1999).
The research proposal is structured as follows: Chapter 2 will provide the literature
review, theoretical background and hypothesis formulation of all parts of the research,
namely, the link between investors’ sentiment and market returns and fluctuation, and
the relationship between investors’ sentiment and the aggregate market mispricing.
Chapter 3 discusses the data gathering and the empirical methodologies. Finally, in
writing the dissertation we will add chapter 4 will present the research results,
conclusions, limitation and recommendations.

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 Chapter 2

Literature review and hypothesis formulation

In this chapter, we provide a comprehensive review of the relevant literature to the research
problem, and based on that review, we form our research hypothesis. Firstly, we discuss the
theoretical background of the research topic and we focus on the transition from the
traditional finance to the behavioral finance and the emergence of the investors’ sentiment
concept, which is the major focus of our research. Secondly, we review all related studies
that: 1) discuss the different measures that are used as proxies for investors’ sentiment as
well as the studies that construct a customized investors’ sentiment indexes, 2) test the
relationship between investors’ sentiment and stock market behavior in both emerging and
developed stock markets.

2.1 Theoretical backgrounds

In this theoretical background, we show that the concept of investor sentiment, the
major focus of our research, has emerged when the behavioral finance theory
challenged the traditional finance theory and proved that investors rationality are
questionable, and investor sentiment play an important role in the investors decision-
making process and asset pricing.
2.1.1 Traditional finance theory
Traditional finance theories assume the efficiency of markets and rationality of
investors that conduct their investment decisions to maximize their wealth. These
theories also assume that investors will offset any asset mispricing by the unlimited
arbitrage opportunities (see, among others, Fama, 1991). The early use of the concept
“efficient market" was done by (Fama, 1965a) efficient market is defined as: "a
market where there are a large numbers of rational, profit maximizers investors who
are actively competing with each other, trying to predict future market values of
individual securities, and where important current information is almost freely
available to all participant", (DeBondt and Thaler, 1985, p. 4).

The efficient market hypothesis (EMH) is based on the assumption that all investors
in any given financial market are rational investors. It also assumes that prices will
not be affected even if there were a number of irrational investors as their random
trades will eventually cancel each other out and even if a random anomaly exists,

11
arbitrageurs will eliminate this effect on market value. Previous work on the sixties
and seventies find support for EMH by both theory and empirical work. (Shleifer,
2000).

However, some researches that were conducted later didn’t support efficient market
theory, (Shefrin and Statman, 2000). More specifically, some researchers including
(Nicholson, 1968; Basu, 1977) challenged the efficiency of security prices by
suggesting stock with high price/earnings multiple are considered to be overpriced
and vice versa. Moreover, Keim (1983) studied the abnormality of return distributions
in the month of January, which he found to have significantly larger means than the
remaining eleven months of the year. This is commonly known as the January effect.

For the past four decades, the efficient market hypothesis (EMH) was the main
reference for the traditional theory of finance. EMH assumes that at any point in time
prices show the reflection of accessible data. (Fama, 1970, 1991). However, this
theory has been challenged immensely recently due its lack of explanation for the
significant volatility in stock returns and trading volumes that were recorded in both
developed and emerging stock markets. On this subject, (Lo, 1997) argued that:
“EMH is disarmingly simple to state, has far-reaching consequences for academic
pursuits and business practice, and yet surprisingly resilient to empirical proof or
refutation”.
The topic of the EMH is considered a controversial one by both academic researchers
and practitioners. The EMH finds support in theory, but questioned by most
researchers. Practitioners however do not give much attention to the EMH (see,
Burghardt, 2010). From an empirical prospective, there are three main directions in
testing the EMH. The first of which being the weak form, which are tests that try to
prove that historical information can predict returns. Under semi-strong form, public
information help to forecast returns. Finally, is the strong form test that focuses on
whether or not investors with private information can use this information for their
advantage in their trading activities.
Researchers have challenged the EMH since its existence both theoretically and
empirically. The main challenge focuses on the area of the rationality of investors,
where it has been proven that investors are in some cases biased in their decision
making which in turn results in unfavorable outcomes. (Shefrin and Statman, 1985)

12
claim investors keep losers and sell the winners. In addition, it was also noticed in a
separate research that traders doesn’t like to have losses. (see, among others, Odean,
1998). And investors suffer losses by trading (Barber et al, 2009).
In addition to the aforementioned deficiencies of the traditional finance theories,
empirical researches of stock markets have shown several inconsistencies that the
traditional finance theories are still struggling to clarify. Examples of these
inconsistencies are: The size effect, which stated that, stocks with small market
capitalization, on average, gain a larger risk adjusted return than stocks with large
market capitalization (Banz, 1981).The value effect, which illustrated a relationship
between the price to earnings ratio and the risk adjusted stock returns (see, Basu,
1977). For instance, (Fama, French, 1992) showed that book-to-market ratios are
positively correlated with stock returns. Short-run price momentum effect, which
refers to the observable fact that historical returns forecast future returns. For
example, (Jegadeesh and Titman, 1993) formed two portfolios, one that had a great
performance in the past three months; the other had the worst performance in the
same sample period. Then they bought the wining portfolio and sold the losing one.
The result was that their trading strategy provides positive returns in the next three
months to one year and they concluded that the momentum was not due to the risk
level of the chosen stocks. The reversal (contrarian) effect, (DeBondt and Thaler,
1985) also combined two portfolios, one is consisted of winners and the other is
consisted of losers and they discovered that losers beat the winners in the next three
years. This reversal strategy suggests buying the outperforming portfolio and selling
the underperforming portfolio. Total accruals; For example (Sloan, 1996) argued that
on average, firms that carry a high level of accruals earn significantly lower returns
than companies that carry lower accruals.
Investment to assets, (Titman et al, 2004) claimed that higher past investment forecast
significantly lower expected returns; (Fama and French, 1992) in a sense that
companies with higher profitability levels tend to have higher expected returns than
companies with lower profitability levels, which indicate the anomaly of return to
assets; Asset growth which represent the phenomenon of companies that earn lower
subsequent returns when they grow their total assets more in a specific period, (see,
among others, Cooper et al, 2008 ); Financial distress; some researchers such as
(Campbell et al, 2008) showed that firms with a higher financial distress probability,
tend to have lower expected returns.

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These anomalies are a few of other examples and they represent some kind of
deviation from market efficiency, which is an important pillar of traditional finance,
and was proven inadequate in explaining these anomalies.

2.1.2 Behavioral finance theory

The field of behavioral finance was initially created as a result of the criticisms
towards the traditional financial theories by several researchers such as Kahneman
and Tversky. Researchers found that traditional financial theories failed to explain the
market anomalies. Behavioral finance is proclaimed to look at finance from a much
broader prospective, one that is related to social science. Many researchers including
(Shiller, 2003), consider this area as one of the main research topics that directly
challenges the hypothesis of EMH. (See, Shiller, 2003, p. 83).

According to (Barberis and Thaler, 2003, p. 1053-1054), there are two main pillars
that define the field of behavioral finance, namely: the limits to arbitrage and
psychology. One of their main assumptions is that arbitrageurs do not have the ability
to eliminate the occurrence of mispricing at all times as suggested by the EMH. In
fact, they assume that in some cases a mispricing in any given market may stay
without challenging. The second pillar, psychology, looks at the factors influencing
investors' investment decisions. This area gained significant traction in several market
crashes including the stock market crash of 1997, the Asian crisis of 1997, and the
financial crisis of 2008 where psychology of investors was considered as one of the
main influencing factors in the financial market (DeBondt et al, 2008, p. 7).

Moreover, there are several empirical anomalies that the EMH failed to clearly
explain including that at certain instances the fragility in financial markets contradicts
the assumption that decision making across all investors is independent. Researchers
have shown that a number of influential investors declared that their investment
decision process can sometimes be influenced by other investors (Devenow and
welsh, 1996, p. 605). This phenomenon in behavioral finance is defined as the herding
effect (DeBondt et al, 2008, p. 9).

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Behavioral finance has also challenged the concept of complete rationality of
investors by illustrating that investors are highly influenced by their own sentiment
leading to a biased investment decision process. This was the basis of the research
conducted by (Hung et al, 2015; DeLong et al, 1990) which concluded that investor
sentiment is a systematic risk element in which has a direct influence on how stocks
are priced in the market. This dissertation is mainly focusing in this cognitive bias,
called investors’ sentiment, which will be reviewed considerably in the next
subsection of this literature review.

As a result of the many challenges to the traditional finance theory, which focused
mostly on the behavioral elements influencing decision making, the emergence of
behavioral finance was inevitable. As defined by (Shleifer, 2000), behavioral finance
is the “study of human fallibility in competitive markets”. Researchers in this filed
focused on finding answers to the challenges and criticism raised against the classical
finance theories. Thus, it was concluded that financial models should not assume that
all investors are rational (see, Barberis and Thaler, 2003), and should incorporate two
main attributes, psychology and the limits of arbitrage, which we discuss
comprehensively in the next section.

2.1.2.1 Psychology
The first pillar of behavioral finance is psychology. Behavioral finance raised many
questions about the rationality of all investors in financial markets, and there are a
number of studies that suggest that individuals are subject to many cognitive biases
when they create their investment decisions. For example, the overconfidence of
investors in their judgment and the overestimation of their abilities in investment
related decision-making. People might become overconfident if they succeeded
several times in their forecasting of some stock’s return (see, Gervais and Odean,
2001).
In the next sub-section, we pay close attention to the notion of investors’ sentiment as
a very important component of behavioral finance and as the core part of this
research.

The role of Psychologists in explaining the nature of the mistakes in which traders are
making in their respective investment decision-making was instrumental. These errors
were defined as the main factors that contribute towards the mispricing of financial

15
assets. After years of research, psychologists concluded that there are three main
types of errors (Hirshleifer, 2001): "1) self deception biases, 2) heuristic
simplification, and 3) emotion effect". The following section will discuss each of
these error types along with the different biases that relates to each type.
1) Self-deception biases, such as: overconfidence which can be defined as the
tendency that investors have in believing that they have the ability to assess the
probability of a certain event happening more than other investors. This results in
investors (including money managers, and financial advisors) having the false
perception of being more informed than others resulting in an adverse effect on their
returns. Conservatism is another self-deception bias, which was first introduced by
(Edwards, 1968) and defined as the individual's inability to change his/her existing
beliefs in light of new evidence. This bias also refers to as the tendency of investors to
keep their previous position in spite of getting new information against that position
(see, among others, Bodie et al, 2009). Finally, Illusion of control that refers to the
belief that an individual has the ability of influencing uncontrollable events. For
example, many investors use charts to make their investment decision, although charts
in theory are not useful in forecasting the future performance of any given stock.
(Taylor and Brown, 1988) define illusion of control as a false perception of an
affair.
2) Heuristic simplification such as representativeness, which was coined by (Tversky
and Kahneman, 1974) and considered as a cognitive heuristic, in which decisions are
made, based on a certain characteristic of a company and expanding it on other
aspects of that same company. This usually results in investors assuming that good
companies are good stock picks in terms of value. Framing is another heuristic bias
that refers to the variation of investors’ decisions under different circumstances (see,
Tversky and Kahneman, 1981). In their pioneer paper, (Kahneman and Tversky,
1979) attributed this variation in decision making to the change of behavior when
investors are faced with the possibility of incurring some kind of loss. Anchoring is
also a bias that refers to the tendency of individuals not to change their opinion once
they form it, regardless of any new relevant information they might receive.
Anchoring manifest itself in a phenomenon called the “post-earnings announcement
drift”. Stock market reacts gradually, not instantaneously, to unexpectedly bad (good)
news in regard to earnings. (Tversky and Kahneman, 1974) emphasized on this
cognitive bias when they found in their research that investors find it difficult to

16
adjust their estimate away from their initial ones. Availability is considered a bias and
refer to the notion of believing that things that are easily remembered are considered
to be more common. (Kliger and Kudryavtsev, 2010) defined availability as:
“people’s tendency to determine the likelihood of an event according to the easiness
of recalling similar instances and, thus, to overweight current information as opposed
to processing all relevant information”. Finally, Loss aversion/ prospect theory which
is looked at as another bias and was defined by (Tversky and Kahneman, 1991) as the
desire of investors to not losing any of their investment rather than gaining something.
3) Emotion biases (sentiment). Mood is the most famous example of these biases, It
is a well-known psychological principal that the existing mood state of an individual
will play a role in the way he makes decisions (see for example Forgas, 1995 and
Clore and Parrott, 1991) In other words, individuals that are in a good mood tend to
be more optimistic than others in worse moods. (Loewenstien et al, 2001) argued that
the impact of the mood on the individual decision-making process increases when the
decision involve risk and uncertainty. Some researchers found a connection between
the weather and the mood of individual and studied the impact of good/bad mood in
relation to the weather on the equity returns. Examples are (Hirshleifer and Shumway,
2003; Cao and Wei, 2005) who found that the increased level of clouds, which is
linked with depression, has a negative effect on equity returns and low temperatures
have a positive effect on equity returns.
2.1.2.2 The limit of arbitrage
We can define arbitrage, the second pillar of behavioral finance, as “the simultaneous
purchase and sale of the same or essentially similar, security in two different markets
for advantageously different prices” (Sharp and Alexander, 1990). Arbitrage in this
sense is founded on the difference in evaluating a security and its substitute, which
has same risk characteristics. In practice, almost no security has close substitute,
which makes arbitrage almost impossible for the rational investor and even when
securities have an existing substitute, securities’ prices will not converge to their
fundamental value immediately because of the continuous movement of prices done
by irrational traders. Arbitragists in this case, face the risk of liquidating the stocks
prior to price convergence with value. Thus, arbitrage gets risky and constrained and
causes prices to remain inefficient. (See, Burghardt, 2010)

17
Limits of arbitrage is an important issue of behavioral finance, it directly challenges
traditional financial theories by highlighting the fact that traditional theories
undermines the way investors make their investment decisions and the implications of
their cognitive biases (Barberis and Thaler, 2003).

One of the main assumptions of the traditional financial theory is that any mispricing
of financial assets is corrected by arbitrageurs who revert them to their fundamental
values. However, behavioral finance suggests that several factors should be
considered to realistically make a profit from an actual arbitrage opportunity
including the costs and risks associated. Specifically, costs include associated
commissions and bid-ask spread cost, while risks include what is called the
fundamental risk which is defined as the risk associated with buying a specific stock
and shorting its substitute (see, Barberis and Thaler, 2003).
.
Another important type of risk is the existence of noise traders who are defined as
traders that pick securities based on their own research, which they believe will result
in a profit. (See, Black, 1986). The existence of those noise traders can result in losses
to arbitrageurs who might be forced to liquidate their positions especially in short
selling (see, Shleifer and Vishny, 1997)
In the next subsection, we will discuss in details the notion of investors’ sentiment as
one of the major cognitive biases brought up by behavioral finance, and as the major
focus of our research.

2.1.3 Investors’ sentiment

As we mentioned earlier, traditional financial theory proposes that the market is

efficient, all investors are acting in a rational way, and the stocks’ price has
satisfactorily reflected all the information in the market, so the stock’s price cannot be
influenced by investor sentiment. Nevertheless, in light of the advancement of the
financial market, many “anomalies” become hard to explain by only looking at the
traditional financial theory and several scholars started to distrust the assumption of
market efficiency, and a newly developed field of behavioral finance has materialized.
Behavioral finance doubted the assumption of investors’ complete rationality and
stated that investors tend to be influenced by their own sentiment when they make

18
their investment decisions, which leads to bias of irrationalities in these investment
decision. As a result, investor sentiment may be a systematic risk factor that affects
stock returns (see, Huang et al, 2015) similarly, (DeLong et al, 1990) proved that
investor sentiment is an intrinsic factor, which affects the equilibrium price of the
stock with a noise trader model. Investor sentiment exists when security prices are
deviated away from their fundamental values. There are two main explanations for
this deviation, the first of which is that investors may be biased prior to the allocation
of value-relevant event results (see, among others, Baker and Wurgler, 2006; Baker
and Wurgler, 2009; Kaustia et al, 2008). The second is related to irrational reactions
of investors due to uncertainty (Bernile and Lyandres, 2011).

Despite the different efforts to define investors' sentiment, finding a clear definition
remains a challenge. (Klein and Zwergel, 2006 and Schmeling, 2007) in their
research used investors' sentiment in the form of "long and short term sentiment"
which is linked to the observation period of stock markets.

One of the major challenges in this area relates to finding the best methodology to
measure investors' sentiment. Related literature generally suggests three main
measures:

The first method uses a "survey-based" approach that includes seeking investors'
views on stock markets resulting in a measure of sentiment related to the type of
mood that investors have. Examples of this method include "the American
Association of Individual Investors (AAII), Investors Intelligence (II) surveys (Verma
and Soydemir, 2006 and Fong, 2013), and the Consumer Confidence Index as a
general measure is also used (see, Schmeling, 2009)".

The second method uses “objective” indicators in relation to financial market. The
review of theoretical and empirical works devoted to stock market behavior and
investor sentiments shows that various measures to quantify the investors’ sentiments.
Briefly, we can range these measures within at least fifteen major empirical
approaches:
i. Direct and indirect survey studies: the underlying idea is to survey the
investors’ belief and attitudes about the stock market. For the direct
surveys, they are implemented choosing randomly investors to answering

19
 specific questions that reflect their beliefs and attitudes in regard to the
stock market (see, among others Seyhun, 1998). Similarly, the indirect
surveys involve asking a random sample of investors indirectly about their
points of view of securities prices, to form an index that is called consumer
confidence index (CCI), (see, among others, Brown et al, 2005; Warther
and Vincent, 1995; , and Lamont and Frazzini, 2005).
ii. Mutual fund flows: Essentially, this proxy is narrowed on how investors
are moving into and out of mutual funds in order to attain higher return
and by changing their portfolios allocations decisions designing their
hedging strategies using various safe or risky funds. Following, (Brown et
al, 2005), (Warther and Vincent, 1995); (Lamont and Frazzini, 2005). ,
such switching behavior may be used as an indicator of investors’
sentiment.
iii. Trading volume: The exchange volume or liquidity can be regarded as an
investors’ sentiment measure. In this regard, investors will most likely
trade and increase liquidity if they are hopeful and expecting the rising of
shares. Conversely, they will not trade and liquidity will decrease if they
are doubtful and expecting the declining of shares. This proxy of
investors’ sentiment could be represented by the market turnover. Several
researchers including (Scheinkman and Wei, 2005) and (Baker and Stein,
2004) employed the trading volume as a suitable measure of investors’
sentiment. We perceive that the main feature of such measure is the data
availability, which can help to identify the structural changes of the
investors’ sentiment over time.
iv. Option implied volatility: There is a well-documented correlation between
the price of stock options and the volatility of the underlying stocks.
Practitioners are calling the market volatility index (see, among others,
Whaley, 2000) that is used to measure the implied volatility of option as
“investor fear gauge”, and researchers are using this index as a proxy for
investors’ sentiment. Although it is an accurate measure of investors’
sentiments based on the time varying implied volatilities, this index cannot
be used in the Saudi market given the absence of stock options in the
Saudi market.

20
v. IPO first-day returns and IPO trading size: The IPO market is commonly
perceived as a very thoughtful tool gauging market sentiments.
Additionally, the occurrences of high first-day returns of IPOs might be
assimilated to a proxy of the level of investor eagerness. Concerning the
IPO exchange size, it is used as a measure of investors’ sentiment. The
main idea is found on the argument that the demand for IPOs is sensitive
to investor sentiment. This argument is closely connected to the market
timing hypotheses (see, Baker and Wurgler, 2006), suggesting that firms
take advantages of periods of market eagerness or excessive sentiment to
issue new equity. Even if the IPO proxy is based on some solid theoretical
arguments, its use as a measure of the Saudi investors’ sentiments is
subject to criticism for at least two main aspects. Firstly, low frequencies
IPOs in the Saudi market, will not allow for an accurate measure of
investors’ sentiment. Secondly, investors’ trading during IPO may be
affected by other global or specific factors affecting the Saudi economy or
Saudi firms and therefore, the IPO trading volume may reflect
appropriately the investors’ sentiments.
vi. Insider trading: Theoretically, insider trading happens when informative
individuals manage their portfolios based on essential information that is
not available to the other investors. Hence, if we leave the legal issues
apart, those individuals’ personal portfolio decisions might similarly show
their point of view about the mispricing of the companies that they acquire
their private information. According to (Seyhun, 1998), if sentiment
indicates simultaneous mispricing throughout companies, then insider-
trading patterns might be viewed as a proxy of investors’ sentiment.
vii. Closed-end Fund Discount: Several scholars such as (Zweig, 1973; Lee et
al, 1991; and Neal and Simon, 1998) presuppose that if closed-end funds
are excessively carried out by investors, the common reduction on closed-
end equity funds is looked at as a sentiment index. (Canbas and Kandir,
2009) also used the closed-end fund discount among other proxies to
measure the investors’ sentiment. This index of investors’ sentiment is
strongly based on equity funds behavior and assumes that these funds are
mainly carried out by retail investors, which may be unrealistic in the
Saudi context.

21
viii. The dividend premium: In the behavioral finance literature, it is commonly
recognized that investors consider dividend-paying securities as a source
of safe investment, and they also consider a superior for those dividend-
paying securities, which might be contrariwise linked to is computed as
the difference between market to book value ratio of dividend-paying and
no dividend-paying securities. This argument was enhanced by (Baker and
Wurgler, 2006) and the dividend premium is selected when quantifying the
investors’ sentiments. Based on the above arguments, we perceive that this
measure is strongly affected by the dividend distributions and their
inherent premiums, which might be inversely associated to investors’
sentiment and does not consider other specific or market factors that may
affect the sentiments. Selecting such proxy to measure Saudi investors
sentiments might be weak hypothesis since asset allocations decisions and
portfolios’ strategy designing are not entirely based on dividends.
ix. Retail investor trades: According to (Greenwood and Stefan, 2006),
(Barber et al, 2003) and (Baker and Wurgler, 2000), retail investors are
commonly viewed as the young and inexperienced investors. They
conjecture that their asset allocation decisions are strongly affected by
their own sentiments, and they tend to buy and sell equities at a relatively
erroneous timing. Based on this argument, some researchers suggested the
use of such retail investor’ trades as a proxy of investors’ sentiments built
on whether those investors are purchasing or vending securities, example
is (Yang and Wu, 2011). This measure seems to be relevant for our
research given that the Saudi market is mostly governed by retail
investors. These retail trading represent therefore a major part of the
trading volume in the Saudi market. We expect that the use of trading
volume is more relevant since it encompasses all types of traders in the
Saudi market.
x. The percentage of equity issues on entire novel issues. It is the equity
percentage of the entire equity and debt for all listed companies in the
stock market. In this measure, we include all equity offering, not only
initial offering. Researchers including (Baker and Wurgler, 2000) showed
that high equity percentage is associated to low stock return, suggesting
that firms are shifting between equity and debt in order to decrease the

22
 general charge of capital. We perceive, that such investors’ sentiment
measure has some main advantages in terms of data availability and easy
computations but it cannot be used in the Saudi market given the limited
new issues. The use of this measure may induce a significant bias if the
number of new issues is limited.
xi. The put call ratio (PCR). This measure of sentiment is represented by the
following equation:
PCR= volume of put option contracts / volume of call option contracts.
This measure was used by a number of researchers such as (Dennis and
Mayhew, 2002)
xii. Net cash flow into mutual funds: this measure refers to the percentage of
cash held in mutual funds, (Randall, Suk and Tolly, 2003; Chi, Zhuang
and Song, 2012) used this measure as a proxy of investor’s sentiment
when the study the relationship between investors’ sentiment and the stock
market behavior.
xiii. Risk Appetite Index: this measure of investors’ sentiment was used by
some researchers such as (Kumar and Persaud, 2002) and it is calculated
as the Spearman rank correlation of volatility versus excess returns.
xiv. Technical Analysis: (Sturn, 2014) in his article “ A turning point method
for measuring investor sentiment”, tried to link technical analysis to
investors’ sentiment by arguing that even though investors’ sentiment may
not be observable, price changes are observable and will be used as a
reflection of investors’ behavior that represent their sentiment.
xv. News articles (media): some researchers argued that investors are affected
by the news , for example (DeLong et al, 1990). Some other researchers
succeed in showing that news could cause over and under reaction to
security prices, (Barberis et al, 1998) argued that investors are influenced
by the news in a slow matter that will be reflected later on the security
prices.

The third method aims to mine for a relevant sentiment measure out of a subset of
financial and economic indicators by using composed indices. In order to avoid the
pitfalls of the investors’ sentiment measures that were discussed when reviewing the
literature in this regard, we will construct a sentiment index that includes a number of

23
measures. Following the steps of some researchers, as we will discuss in this section of
our literature review.

One of the major attempts to construct a sentiment index was proposed by (Baker and
Wurgler, 2007) who discussed many sentiment proxies such as trading volume, IPO
numbers, IPO first day return, mutual fund flows, dividend premium and insider
trading. In choosing the right variables for constructing their index, the researchers
consider data availability as the major selecting factor and they narrow their choices to
six proxies, namely, trading volume, dividend premium, the closed-end fund discount,
the number and first day returns on IPOs, and the equity share in new issues. As a next
step, the researchers tried to remove the influence of some macroeconomic variables
on these proxies, they regress each proxy on a set of macroeconomic factors, more
specifically, growth in industrial production, real growth in consumption, growth in
employment and recession indicator. They used the residuals from those regressions as
sentiment proxies. To construct the index, it is simply the first principal component of
the six proxies.

Another attempt to construct a sentiment index was done by (Chen, Chong and Duan,
2010). They also used the principal component approach to construct a sentiment
index in the Hong Kong stock market. They include the following proxies: the stock
market turnover, short selling, interest rate, the relative strength index (RSI) which
shows if the market is overbought or oversold, the last factor used to construct their
index was the performance of the S&P 500 and the NIKKEI 225 after taking the time
– zone difference between US and Japan. The data used to construct this index covers
the period 1998-2006.

(Chen, Chong and She, 2013) constructed another sentiment index for the Chinese stock
market. They also used the principal component approach and considered some
economic factors such as : interest rate, exchange rate, industrial production, and money
supply. They include market-based factors such as : stock market turnover and the
number of new investors accounts. They constructed their index based on data collected
over the period 1997-2010.

24
For the purpose of this research, we follow baker, Wurgler, (2007) approach in
constructing the sentiment index in the Saudi stock exchange as detailed in the
methodology section of this research.

Each of the three cited methods has its own disadvantages. For the first method, the
costs associated with conducting a proper survey could be problematic especially
when quick questionnaires do not result in a relevant outcome. As for the second
method, using these "objective" indicators may capture the stock price movement
rather than the actual purpose of measuring sentiment. (Wang et al, 2006) study the
ratios of Put-call trading, where they discovered that using them to measure sentiment
maybe not accurate as movements could be caused by stock returns rather than
sentiment. In addition, using a set of principal components to create a "composed
index" may also not be a very accurate measurement method as the selection criteria
used to select the components may change in light of new information. It is worth
mentioning however, that "composed indices" are the most popular measuring method
used, as it is immune to the reliability problem that exists in surveys and has the
appropriate level of independence that pure financial data lacks. Based on this
argument, the researcher will construct an investors’ sentiment index for the Saudi
stock market.

2.2. Review of the related studies

In this section of our literature review, we concentrate on the related studies that
explored the relationship between investors’ sentiment and the stock market behavior.
The relationship between investors’ sentiment and stock market behavior was
investigated by many researchers all over the world. In this section of our literature
review, we discuss some of these researches both in emerging and developed stock
markets.
2.2.1 Studies in developed countries
Sinha, (2016) for example compares the impact of news articles and sentiment on the
US stock market returns. His findings reveal that the market needs around a quarter
(13 weeks) to integrate information from news articles. On the other hand, sentiment
has no lasting impact on stock prices.
Da et al, (2015) use an innovative measure of sentiment called “the sum of all fears”
in which they searched the internet for household queries such as bankruptcy,

25
unemployment and recession, They use the aggregated volume of the queries to
construct their FEAR index and use it as a proxy to measure its impact on asset prices
and volatility. The results show that their constructed index could forecast aggregate
market return and is correlated to today’s low return and predict tomorrow’s high
return. Furthermore, they conclude that the index’s impact is stronger in stocks that
are preferred by sentiment investors and difficult to arbitrage. They also find that their
index is highly correlated with daily volatility (Da et al., 2015, P.29)
Bathia and Bredin, (2013) investigate the relationship between investors’ sentiment
and the stock return in seven countries, namely, USA, Canada, UK, Germany, France,
Italy and Japan. They test the impact of investors’ sentiment on the aggregate market
returns and on two types of stocks: value stocks and growth stocks. As an investors’
sentiment measure, they used four different proxies: consumer confidence index,
equity fund flow, the closed end equity fund, and equity put/call ratio. Their data
covers the period 1995-2007, and their results revealed different impact of investors’
sentiment on market returns based on the measure that was used and on which type of
stock they were testing in each of those seven markets.
Similarly, another research conducted by Baker et al., (2013) also tries to investigate
the relationship between investors’ sentiment and stock market returns in six
countries: UK, France, Japan, USA, Canada and Germany. They used data of several
investors’ sentiment proxies from 1980-2005 to construct six sentiment indices for
each of the six countries and a single global index for all of them. One of the major
contributions of this work is the linkage between investors’ sentiment indices and
Siamese twins’ share prices that is dual-listed shares which have the same cash flows,
however traded in different markets for different prices. They found that global
sentiment is statistically and economically significant contrarian predictor of market
returns (Baker et al, 2013, P. 286)

Finter et al., (2011) construct an index using a number of sentiment proxies to test the
impact of investors’ sentiment on the German stock market returns. Their results
show that investors’ sentiment has a significant impact on stock returns, however it
doesn’t cause mispricing in the long run, due to the fact that the German stock
exchange is dominated by institutional investors and not retail investors.

2.2.2 studies in emerging markets

26
The work of Chi et al., (2012) use mutual funds flow as proxy for investors’ sentiment
to test the relationship between investors’ sentiment and stock market returns in
China. The result of this study show that high sentiment stocks earn higher returns
than the low sentiment stocks. This result contradicts most of the literature findings
that high sentiment stocks should earn low future returns, the authors explain this
contradiction by saying that the Chinese stock market is a young one and traders are
lacking experience and their sentiment has a huge impact on the stock market returns.

Grigaliunien and Cibulskiene, (2010) employ two measures of sentiment: consumer

confidence index and economic sentiment indicator to study the relationship between
investors’ sentiment and stock market returns in the Scandinavian countries (Sweden,
Denmark, Norway and Finland) at the aggregate level and cross-sectionally. Their
results are relevant to the literature empirical findings in which they found negative
relationship between investors’ sentiment and stock returns at different predicting
periods between 1989 and 2009.

The same investigation of the relationship between investors’ sentiment and Indian
stock market returns was conducted by (Dash and Mahakud, 2013). They used
multivariate time series regression for the period 2003-2011, and they controlled for
market size, book to market, momentum and liquidity variables, they also constructed
an index for sentiment by using several market related sentiment proxies. Their results
were consistent with the literature empirical findings that there is a negative pricing
impact of sentiment on stock returns.

As it is evident from the above review, the studies carried out in the context of both
developed and emerging markets bring out similar results. All studies acknowledge
the presence of significant relationship between investors’ sentiment and stock market
behavior. The only difference is, it is affected by the dominance of institutional
investors.

2.3. The relationship between investors’ sentiment and stock market behavior
In this section, we highlight the results of studies that focus on three specific aspects
of stock market behavior: stock market return, volatility and mispricing.

2.3.1 The relationship between investors’ sentiment and stock market returns

27
There has been significant traction when it comes to research papers discussing how
sentiment influences stock returns. For example, Lee et al., (2002) shows excess
returns and sentiment changes move in the same direction. Market trend results in
varied sentiment and alters volatility and excess return. Brown and Cliff, (2005) Find
that investor sentiment cannot predict future return in the short run, and it is
negatively correlated with returns of the next one to three years. Baker and Wurgler,
(2006) argue that market-wide sentiment should exercise greater influences on stocks
that are not easy to assess and arbitrage. Lemmon and Portniaguina, (2006) show that
investor sentiment has a negative consequence on value stocks, but has no significant
impact on growth stocks. Stambaugh et al., (2012) demonstrate that a wide group of
anomalies are greater if they follow high levels of sentiment, and the short stand of
each strategy is more beneficial succeeding high sentiment, but sentiment shows no
relation to returns on the long stand of the strategies. Baker et al., (2012) prove that
global sentiment is a contrarian forecaster of country-level returns. Both international
and local sentiments are contrarian forecasters of the time series of cross-sectional
returns within markets. Wang and Sun, (2004) show that investor sentiment does not
only affect the returns of Shanghai and Shenzhen stock markets, but also reversely
corrects return fluctuations of these two markets to a large extent. Study by Huang
and Wen, (2009) finds that there is a distinct cross-sectional effect between the
investor sentiment index and the expected return of the market, and the effect is
reflected in return indices for different industries with the largest effect on the
information industry and the least effect on the transportation industry. Furthermore,
Chi and Zhuang, (2009) prove that investor sentiment affects stock returns
significantly, and the effect of optimistic sentiment is greater than that of pessimistic
sentiment. Moreover, extreme sentiment has a special predictive power in the stock
market.

It is clear that studies on investors’ sentiment and stock market returns produce mixes
results. However, Saudi stock market is characterized by retail investors who are
active on daily bases and dominate both the volume traded and value traded, (weekly
stock market ownership and trading activities, TADAWUL, various volumes) .
Hence. It can be hypothesized that investors’ sentiment will have a significant and
positive relationship with stock market returns.

28
Hypothesis 1: investors’ sentiment affect the aggregate stock market return
significantly and positively.

2.3.2 The relationship between investors’ sentiment and stock volatility

In this section of our literature review, we illustrate some studies that investigate the
relationship between investors’ sentiment and stock market volatility. For example
Yang and Wu, (2011) explore the relationship between investors’ sentiment and stock
price volatility in the Taiwanese stock market, they identify a sequential relationship
instead of a causal one. This sequential relationship allows testing different factors of
sentiment such as buy/sell orders, and put/call ratios in a sequence that reflects their
importance in influencing price volatility. Their study covers the period 2002-2008
and they used eight different sentiment proxies, which were grouped in four major
categories. Their findings showed that the influence of these measurements on
volatility ranged from weak to strong.
A study conducted by Spyrou, (2012), tries also to relate the changes in investors’
sentiment to the stock market returns and volatility in the United States. They
compiled a portfolio from all three stock markets: NYSE, AMEX and NASDAQ with
the application of high minus low (HML) and small minus big (SMB) factors, and
based on market capitalization, Book/Market, Momentum and long term reversal, and
then calculated monthly returns on that portfolio for the period 1965-2007. For
measuring sentiment, the researcher constructed an index similar to (Baker and
Wurgler, 2006). The results showed that sentiment changes don’t have any significant
influence on volatility.
Rehman, (2013) explores the relationship between investors’ sentiment and the
Karachi stock market volatility, he measured sentiment by an index similar to the
index constructed by Baker and Wurgler, (2006) and use a regression equation to test
that relationship. He concludes that sentiment has a significant impact on stock prices
volatility.

Behavioral finance theory and the existing empirical works in the domain show that
there are two kinds of investors; rational investors who trade on the strength of
fundamentals and the other type of investors who carry out trades based on noise
signals and are driven by irrational sentiments. The noise traders, investors with
sentiment, affect the level of asset pricing through their trades during bullish and
bearing outlook. Concerted trades by noise traders will impact prices and let it deviate

29
from the fundamental values as arbitrage gets risky and rational investors may abstain
from effort to restore their fundamental values. Presence of investors’ sentiment adds
to the systematic risk of the market place that is priced. This risk causes price
volatility of assets. Ability of arbitrageurs to contain the impact of trades carried out
by the noise traders is constrained as rational investors are expected to be risk averse
and invest over short horizons. Hence, they are not likely to trade against investors
with sentiment. Arbitrageurs are restricted by the limits to the power of arbitrage. The
studies that evaluate the relationship between investors’ sentiment and stock price
volatility produce contradicting results. As argued earlier, Saudi stock market is
predominantly driven by active retail investors on a daily bases. Hence, we expect a
significant positive relationship between investors’ sentiment and stock market
volatility as follow:

Hypothesis 2: investors’ sentiment affects the stock market returns and volatility
significantly and positively.

2.3.3 investors’ sentiment and stock mispricing

Recent history of high-tech stock market bubbles and several stock market crashes
strengthen the argument of behavioral finance that markets are not efficient and and
that investors, driven by their emotions, can lead markets awry. Stock market may not
reflect economic fundamentals, and according to that point of view, substantial and
lasting deviation from the intrinsic value of stock prices occur in stock markets.
(Ritter, 2003 and Barberis and Thaler, 2003).
In fact behavioral finance theory states that stock markets might fail to reflect
economic fundamentals under three conditions: first, the presence of irrational
investors who don’t correctly process all the available information when they form
their expectation of the stock market future performance; second, the systematic
patterns of those irrational investors, i.e. when large group of investors share specific
pattern of behavior such as overconfidence, overreaction, and over-representation,
finally, the behavior of some investors who assume that the market recent strong
performance alone is an indication of future performance which result in driving up
the stock prices ignoring the underlying fundamentals Goedhart et al., (2005).
Chen et al., (2013) utilize a simple dividend model to explain the sources of market
mispricing and additional fluctuation based on “two hypotheses – inflation illusion
and heterogeneous beliefs”. They based their analysis on a theoretical framework,

30
which stated that “equity mispricing arises when investors have subjective
expectations about discount rates or dividend growth rates”. They found out that
“heterogeneous beliefs play a more important role in explaining stock mispricing in
the long run and cause excess volatility”.

In another study by Daniel et al., (1998), they Propose a model of security market
under- and overreactions built on more than one famous mental biases: “investor
overconfidence about the precision of private information; and biased self-attribution,
which causes asymmetric shifts in investors' confidence as a function of their
investment outcomes”. In et al., (2010) also try to explain the stock market mispricing
using “Fama-French factors” and found support by using the “multiscaling approach”,
namely the “wavelet analysis”. Research findings revealed that at the lower
occurrences are associated with risk elements more than at the higher occurrences in
the classical CAPM. They also concluded that the overreaction-associated mispricing
proposition explain the impact of the volume but not the increased worth.

On the theoretical side, due to the limit of arbitrage, the informed rational traders are
constrained in the presence of traders who are driven by sentiments. On the other
hand, uninformed demand shocks causes mispricing of assets. Presence of free riding
sentimental traders cause mispricing, which could be broad, based. Uninformed noise
traders who are excessively optimistic or pessimistic make a strong and lasting
mispricing in the stock market. This effect is further reinforced by the fact that the
rational investors tend to be trading over short horizons and fear the risk that
deviation from the fundamentals may stay in a market characterized by the noise
traders. Hence, presence of investors, who trade on sentiments cause asset mispricing
in the stock market.

Based on the above literature review and theoretical argument, we formulated our
hypothesis on the relationship between investors’ sentiment and the aggregate stock
market mispricing as follows:

Hypothesis 3: investors’ sentiment affects the degree of mispricing of the Saudi stock
market.

31
 Chapter 3
Research Design

This part of the study includes the research questions, discussion of different
investors’ sentiment measures that have been used in the literature and the advantages
of constructing an index to measure the investors’ sentiment and to be used in
studying the relationship between investors’ sentiment and the Saudi stock market
behavior. It also includes description of the econometric models that will be used to
investigate the study dynamic relationships. A detailed section will be dedicated to
explain the control variables and the logic behind including certain variables and
disregarding the others. Finally, another section will be allocated to the utilized data,
its sources, period and the motivation to use the specific period of study.

3.1 Research Questions:

This study attempts to provide answers to the following questions:
1- Does the investors’ sentiment have any impact on the Saudi stock returns?
2- Does the investors’ sentiment have any effect on the volatility of the Saudi stock
market?
3- What is the relationship between investors’ sentiment and the Saudi stock market
mispricing?

3.2 investors’ sentiment measures:

Finding the appropriate measure of investors’ sentiment is probably one of the most
difficult decisions that researchers in this field are facing nowadays. The literature in
this field suggests many measures that were used as proxies of investors’ sentiment.
In the following subsections, we demonstrate what the literature has to say in this
regard.

3.2.1 Direct measures

Direct measures of investors’ sentiment refer to "survey-based" approach that
includes seeking investors' views on stock markets resulting in a measure of sentiment
related to the type of mood that investors have. Examples of this method include "the
American Association of Individual Investors (AAII), Investors Intelligence (II)
surveys (Verma and Soydemir, 2006 and Fong, 2013), and the Consumer Confidence
Index as a general measure (see, Schmeling, 2009)".

32
These measures have some advantages such as: 1) these surveys are usually
conducted by experience institute, which design these surveys in a way that covers all
aspect of consumer attitudes towards the current and future aspect of the economy and
their investment decisions. 2) They are considered good measures in countries that
started to conduct and develop them for a long time. Unfortunately, these surveys are
not available in Saudi Arabia.
On the other hand, they have some disadvantages because these measures are time
consuming and should be done by professional institute who has the expertise and
tools to conduct such surveys over a long period of time. In addition, the costs
associated with conducting a proper survey could be problematic especially when
quick questionnaires do not result in a relevant outcome. Individual researchers
cannot afford both the time and cost of these surveys.

3.2.2 Indirect measures

These indirect measures refer to methodologies that use “objective” indicators in
relation to financial market. Examples include “the put-call trading ratio and indices
of volatility” (Rekik and Boujelbene, 2013). As may be recalled, in our literature
review, we have discussed the most cited proxies of investors’ sentiment that are used
by researchers all over the world. The list include measures like: trading volume,
mutual fund flow, IPO size and first day return, insider trading, closed-end fund
discount, dividend premium, risk appetite index, and news articles.
Similarly, these indirect measures of sentiment have some advantages and
disadvantages. Advantages are realized from the readily available data that could be
used to utilize these measures as proxy of sentiment. Disadvantages rely on the
limitations of these measures to represent different aspect of investors’ sentiment.

3.2.3 Index construction

In view of the limitations that both direct and indirect measures of investors’
sentiment suffer, as we outlined in the preceding sections, we construct a sentiment
index that adopts a top down and macroeconomic approach following the steps
proposed by Baker and Wurgler (2007). An external shock on investor sentiment
may have ramifications that results in a sequence of events. Hence, relying on an
investor sentiment measure that uses the trading activity may not be appropriate, as it
will solely focus on the irrational investors’ behavior. We use a set of proxies that

33
puts together several imperfect measures. The proxies that are found in the earlier
works include direct and indirect investor surveys (Brown and Cliff, 2005), investor
mood (Kamastra and Kramer and Levi, 2003), retail investors trades (Greenwood and
Nagel, 2006), mutual fund flows (Frazzini and Lamont, 2006), trading volume
(Scheinkman and Xiong, 2003), dividend premium (Fama and French, 2001), closed-
end fund discount (Neil and Wheatley, 1998), option implied volatility (Whaley,
2000), put-call ratio (Dennis and Mayhew, 2002), risk-appetite index (Kumar and
Persaud, 2002), IPO first-day returns( Baker and Wurgler, 2006), IPO volume (Baker
and Wurgler, 2006), equity issues over total new issues (Baker and Wurgler, 2000)
and insider trading ( Seyhun, 1998).
Lack of applicability of some measures like those related to derivative markets to
Saudi stock market trims down this list. We need data on all the proxies for our entire
study period, 2003 till 2016. So non-availability of data further prunes the list. We
study five of the six proxies of investors’ sentiment employed by Baker and Wurgler
(2006), trading volume, number of IPOs, IPO first day return, dividend premium, and
the equity share in new issues, leaving out closed-end fund discount due to lack of
data. However, we are improving on their work by adding two more proxies to the
list. Since the daily trades in the Saudi stock market is dominated by the individual
investors, we include the retail investors’ trades and substitute closed-end fund
discount with mutual funds flows as a major share of the institutional participation in
the stock market is contributed by mutual funds in this country. Due to the
disagreement on the use of closed-end fund discount as a measure of individual
sentiment (Lee et al., 1991), we exclude this measure, in addition to lack of data
availability. Earlier works show that indirect measures of investor sentiment are
correlated to the direct measures of sentiment. Use of either of these sets of measures
will not distort the findings. (Brown and Cliff, 2004)
In the construction of our index, we control for the impact of macroeconomic
variables on our selected proxies, by regressing each proxy on a set of
macroeconomic variables as previous studies bring out strong correlation between the
sentiment index and macroeconomic variables. (Sehgal, 2010) The control
macroeconomic variables included in the study are: growth in industrial production,
real growth in consumption, growth in employment, growth in money supply, interest
rate and recession indicator. These are the macroeconomic factors included in the
earlier studies. (Baker and Wurgler, 2007; Chen et al. 2014) In addition to these

34
variables, we also include oil prices as oil markets mainly drive Saudi Arabian
economic development.
Next, we use the residuals from those regressions as sentiment proxies. The two most
popular methods used in the literature to extract a single state variable are Kalman
filter and the first principal component analysis. Existing works bring out high
correlation between the results of these two analyses (Brown and Cliff, 2004), we
employ the first principal component analysis as it is the more commonly used
method in works related to investor sentiment. (See for example, Baker and Wurgler,
2006 and 2007; Chen et al. 2010 and 2014)
3.3 Research variables and data sources:
In this section, we illustrate all variables that we use in our empirical analysis. Next
we mention the sources of the data required for each of these variables.
3.3.1 Research variables:
The variables used in this research are classified into four categories:
A- Investors’ sentiment variables
- Sent: investor sentiment index that will be constructed by the researcher using
PCA techniques.
- IPON: initial public offering number during the study period
- IPOR: initial public offering first day returns
- MFF: mutual fund flow
- LIQ: stock market liquidity represented by the stock market volume
- EQP: equity percentage in total new issues

- DIVP: dividend premium that is calculated as the difference between the average
market-to-book ratio of dividend paying stock and non-paying stocks.
- CCI: consumer confidence index
- RIT: retail investor trades
B- Macroeconomic variables
- GIP: growth in industrial production that is calculated as: log (AVIPt/AVIPt-1)
where AVIP is the average of industrial production
- RGC: real growth in consumption
- GE: growth in employment
- RI: recession indicator
- OIL: oil prices
- USEUIt : Is the US economic uncertainty index.
- AI: The annual inflation that is computed as (AVCPIt/AVCPIt-1) where AVCPI is
the annual average of consumer price index;

35
 - GGDP: The growth rate of GDP that is computed as ( GDPt-GDPt-1/GDPt-1);
C- Control variables
- Beta: market risk factor
- Size: stock market size measured by market capitalization
- B/M: stock market book to market value
- LIB: dummy variable to measure the impact of opening the stock market to
qualified foreign investors (QFI)
D- Stock market variables
- Rt: stock market return
- It: Saudi stock market index (TASI)
- 𝜎𝑡 ∶ Saudi market volatility
- 𝐷𝑌𝑡−1 : Divided yield that is computed as (dividend t-1/ market index 1);

3.3.2. Data sources:

In this study, we utilize monthly data for the period January 2003 to December 2016.
We will obtain 168 observations. This period was specified due to the availability of
data on one hand and to capture the influence of investors’ sentiment on stock market
behavior during the financial crises and bubbles that occurred during this period.
All investors’ sentiment proxies’ data will be obtained from the Saudi stock exchange
(TADAWUL) www.tadawul.com.sa. Only data on CCI will be obtained from
www.tradingeconomics.com, CCI is reported by Nelson Company on monthly bases.
Data on macroeconomic variables will be obtained from four sources: the annual
reports of Saudi Arabian monetary agency (SAMA) , www.sama.gov.sa , the website
of the ministry of economics and planning , www.mep.gov.sa, and the general
authority for statistics, www.cdsi.gov.sa, macroeconomic variables related to the US
economy will be obtained from Bloomberg.
Control variables and variables related to the Saudi stock markets will be obtained
from the Saudi stock exchange (TADAWUL) and from the capital market authority,
www.cma.org.sa
3.4 the Models:
In this section, we present our models
3.4.1 The first model: To investigate the relationship between investor’ sentiment
and stock market return

36
In this section, we present our model that test our first hypothesis and answer our first
question about the impact of investors’ sentiment on the aggregate stock market
returns.
This research is testing whether the returns of the Saudi stock Exchange (SSE) are affected by
the investors’ sentiment taking into consideration the control variables such as market
volume, B/M ratio, and market cash. We apply the following OLS regression to test this
relationship.

𝑅𝑡 = 𝛽0 + 𝛽1 𝑆𝑒𝑛𝑡𝑡−𝑔 + 𝛽2 𝑠𝑖𝑧𝑒𝑡 + 𝛽3 𝐵/𝑀𝑡 + 𝛽4 𝑙𝑖𝑞𝑡 + 𝜌𝑡 (1)

Where;
𝑅𝑡 is the stock market monthly return
𝑆𝑒𝑛𝑡 Is the sentiment index
g is the suitable lag

The control variables used in our first model are viewed as essential factors in earlier
asset pricing empirical research. Examples include Dash and Mahakud, (2013) who
controlled for systematic market, size, book to market, momentum and liquidity
(Dash and Mahakud, 2013, p. 139). Another example is the work of Verma and
Soydemir, (2006), they consider market volatility as a control variable when testing
the relationship between investors’ sentiment and the stock market returns.
We include our control variables in order to study the impact of sentiment on stock
returns away from these variables influence. The selection of these variables is
dominated by their data availability. The following control variables were used:
𝑠𝑖𝑧𝑒𝑡 Is the market size
𝐵/𝑀𝑡 is the ratio of market book value to market value
𝑙𝑖𝑞𝑡 is the stock market liquidity

3.4.2 The second model: To investigate the relationship between investor’ sentiment
and stock market volatility.
This research is also investigating the effect of investor sentiment on the Saudi market
fluctuation. We start by calculating the stock market volatility. Stock market volatility is
estimated as the standard deviation of the past month continuously compounded returns,
which measure the uncertainty of the stock market return. With reference to Hull (2007), we
employ the following approach to estimate monthly return:
𝐼𝑡
𝑅𝑡 = 𝐿𝑜𝑔 𝐼 (2)
𝑡−1

37
𝐼𝑡 𝑎𝑛𝑑 𝐼𝑡−1 Are the stock market indexes for (t) and (t-1) respectively.
As in (Hull, 2007), we use the next equation to estimate an unbiased estimate of the standard
deviation rate per month, using the most recent observation on the 𝑉𝑡 to investigate the impact
of investors’ sentiment on stock market volatility
1
𝜎𝑡 = √𝑚 ∑𝑚 2
𝑖=1 𝑣𝑡−𝑖 (3)

Where, 𝑉𝑡 is the continuously compounding return between the end of one month and its
previous month

Next we test the impact of investors’ sentiment on the stock market volatility
At this stage, we use the sentiment-constructed index to test the effect of investors’ sentiment
on the market fluctuation. We control for market risk measure and market liberalization.
We estimate the following regression:

𝜎𝑡 = 𝜃0 + 𝜃1 𝑆𝑒𝑛𝑡1𝑡−𝑔 + 𝜃2 𝐵𝑒𝑡𝑎𝑡 + 𝜃3 𝐿𝐼𝐵𝑑𝑢𝑚𝑚𝑦 + 𝜌𝑡 (4)

Where, 𝜎𝑡 is the one-month volatility of the Saudi stock market, which was estimated in Eq.
(3) 𝜃0 is the intercept. 𝜃1 is the estimated parameter measuring the impact of the investor
sentiment.𝜃2 is the parameter measuring the impact of the market risk measure (Beta), 𝜃3 is
the parameter of a dummy variable that equal 1 when the market was open for foreigners and
zero otherwise. while 𝜌𝑡 is the random error term.

3.4.3 the third model: To investigate the relationship between investor’ sentiment
and stock market mispricing.
This research will utilize the GARCH-M model as it suits the research data. OLS is rejected
because of the homoscedasticity issues. ARCH/GARCH model allows for variation in the
error terms. This problem of hetroskedasticity is factored in ARCH/GARCH model. When
the variations of the error terms are not equal in the data, and the error terms are expected to
be bigger for some points of the data than for others, in this case the data are suffering from
hetroskedasticity. The typical caution is that in the existence of hetroskedasticity, the
regression coefficient for an OLS are still neutral, however, the ordinary errors and
confidence intervals projected by usual measures are very limited, which gives an untrue feel
of accuracy. ARCH/GARCH models handle hetroskedasticity as a variation that should be
demonstrated. Consequently, we correct the shortages of OLS, and we compute an estimate
for the variation of every error term. (Engle, 2001).

38
ARCH-GARCH models requires pretest for ARCH properties and unit root test in the
residual is a prerequisite for these models.

The ARCH properties test:

To check for the existence of ARCH consequences in a given time series, which is essential
for the estimation of different volatility models. The ARCH model is needless and
misspecified, if there are no ARCH consequences in the residuals term.

In the GARCH-M specification

We propose the first model (model 1) and we estimate the following model:

𝑅𝑖𝑡 − 𝑅𝑓𝑡 = ∝0 +∝1 𝑙𝑜𝑔ℎ𝑖𝑡 + ∝2 𝐷𝑌𝑡−1 +∝3 𝐴𝐼𝑡−2 +∝4 ∆𝑇𝐵𝑡−1 +∝5 ∆𝐼𝑃𝑡−2 +
∝6 ∆𝐺𝐷𝑃𝑖𝑡 + 𝛼7 𝑜𝑖𝑙𝑡 + 𝛼8 𝑈𝑆𝐸𝑃𝑈𝐼𝑡 + 𝜀𝑖𝑡 , 𝜀𝑖𝑡 ∼ 𝑁(0, ℎ𝑖𝑡 ) (1)

Where, 𝑅𝑖𝑡 − 𝑅𝑓𝑡 : Market excess return;

𝐷𝑌𝑡−1 : divided yield that is computed as (dividend t-1/ market index 1);

𝐴𝐼𝑡−2 : The annual inflation that is computed as (AVCPIt/AVCPIt-1) where AVCPI is the
annual average of consumer price index;

∆𝑇𝐵𝑡−1 : Change in 1-month T-bill rate (Rft – Rft-1);

∆𝐼𝑃𝑡−2 : Change in industrial production log (AVIPt/AVIPt-1);

∆𝐺𝐷𝑃𝑖𝑡 : The growth rate of GDP that is computed as ( GDPt-GDPt-1/GDPt-1);

𝑜𝑖𝑙𝑡 : Is the monthly crude oil price.

𝑈𝑆𝐸𝑃𝑈𝐼𝑡 : Is the US economic uncertainty index.

A correlation matrix will be administered to insure no high correlation existed between these

time series:

2 −
ℎ𝑖𝑡 = 𝛽0 + 𝛽1 𝜀𝑖𝑡−1 𝐼𝑖𝑡−1 + 𝛽3 ℎ𝑖𝑡−1 + 𝛽4 𝑅𝑓𝑡 (2)

Where, ℎ𝑖𝑡 : Represents the risk-return relation.

39
 −
𝐼𝑖𝑡−1 : Recognizes the asymmetric reaction in investors’ creation of restricted fluctuation to
−
progressive and adverse tremors, that is, Iit−1 =1 if εit  0, and Iit−1
−
=0 then. In conclusion,
Model (1) allow us to examine the relationship between risk and return (1), and fundamental
impacts (2 to 8) on excess stock market returns

next, we test our third hypothesis in regard to the relationship between investors’ sentiment
and the stock market mispricing. To do so, we refer to the Fama-French three factors model
(1996). (FF 3 Factors, herewith). The Fama- French three factors model is used as a
benchmark because it is well documented in the financial literature that the FF 3 factors has a
good ability to describe the stock returns. Many authors have shown that the FF 3 factors
model explain a substantial propositions of stock market return change. Examples are: Cao
and Wei, (2005) who compared the FF3 factors and artificial neural networks in predicting
the Chinese stock market. Barthholdy and Pears, (2005) stated that most experts prefer a one-
factor model (Capital Asset Pricing Model) (hereafter, CAPM) when calculating predictable
return for a single share. In the case of estimating a portfolio returns, researchers suggest the
Fama and French 3-factor model. The key goal of their research is to relate the functioning of
these two models for single shares.

As noted earlier, we refer to the FF3 factors model to test the effect of sentiments on stock
market mispricing. Empirically, we will adapt the following steps:

1- First, we arrange the listed shares into (N) equally weighted portfolios in regard to
their volume and B/M ratios. It is worthily noting that to test the strength of our
outcomes, we estimate the model using the value weighted portfolios.

2- Second, we compute the excess return (ri), as the change between the portfolio return
and the no-risk rate. Then we regress the portfolio return on the market portfolios
return. In addition, we also compute the difference between big stock portfolio and
small portfolio (hereafter, BMS). Similarly, we calculate the difference between
elevated B/M portfolio and small B/M counterparts (hereafter, HML)

3- Formally, the FF 3factors model is given as follow:

𝑟𝑖,𝑡 = 𝛼𝑖 + 𝛽𝑖1 𝑅̃𝑀,𝑡 + 𝛽𝑖2 𝑆𝑀𝐵 + 𝛽𝑖3 𝐻𝑀𝐿 + 𝜀̃𝑖,𝑡

Where, 𝛽𝑖1 are the loading factors, 𝜀̃𝑖,𝑡 is the error term, in the OLS regression of the N
selected portfolio ( i= 1,2,……..,N)

40
 4- We examine the multi-Beta form of Sharpe-Lintner asset pricing model as in Fama-
French (1996).

We test an augmented version of the FF 3 factors by including the investor sentiment

measure. Therefore, our estimated model can be written as follow:
𝑇

𝑟𝑖,𝑡 = 𝛼𝑖 + 𝛽1,𝑀 𝑅̃𝑀 + 𝛽𝑖𝑆 𝑆𝑀𝐵 + 𝛽𝑖𝐻 𝐻𝑀𝐿 + ∑ 𝜆𝑖,𝑗 𝑆𝑒𝑛𝑡𝑖.𝑡−𝑗 + 𝜀̃𝑡
𝑗=0

Where:
𝑟𝑖,𝑡 : is the excess portfolios return (i= 1-N), 𝜆𝑖,𝑗 : is an estimated coefficient measuring the
impact of the actual (current) investors’ sentiment on the portfolios excess return, while 𝜆𝑖,𝑗
for j= 1,………, T is the estimated coefficient assessing the impact of lagged investors’
sentiment on the excess return.

We refer to the F-statistics to check whether the investors’ sentiment component has an

impact on stock market mispricing with reference to the FF 3 factors model (1996). More

precisely, when the estimated coefficient 𝜆𝑖,𝑗 for j= 0,……..T are statistically significant, the

hypothesis H2 is accepted. In other terms, the current and the lagged investors’ sentiments are

able to explain a part of stock return changes that are not considered by the benchmark model

(FF 3 factors model). Subsequently, investors’ sentiment is a potential factor explaining the

mispricing of stock returns in the Saudi market.

41
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