Determinants of Qualified Investor Sentiment

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This entry is adapted from the peer-reviewed paper 10.3390/economies10060143

Risk perception varied widely due to idiosyncrasies in specific countries and regions, the level of pandemic information, reaction to case reports and deaths, attitudes towards vaccination, lockdown compliance, and government measures to support businesses. These various elements combined to create different outlooks in the minds of investors that strongly influenced their investment strategies.

COVID-19 qualified investor investor sentiment VIX VSTOXX implied volatility fear

1. Investor Sentiment

Fama (1991) and Fama and French (^[1] 1996) reviewed the theoretical and empirical evidence for explaining returns, including the use of a three-factor model. The proponents of the behavioral finance framework reject the expected utility theory and claim that stock markets are inefficient systems because investors can be irrational and nonobjective (Sharma and Kumar 2019), causing severe asset price fluctuations and increasing risk. Rational expectations about fundamentals do not drive market risk, and, therefore, investor sentiment must be taken into account. Ir-rational psychology has a more rapid and pronounced consequence on stock market returns than rational behavior (Verma et al. 2008), and is a vital consideration when making investment decisions.

2. Investor Sentiment Vis-à-Vis COVID-19’s Effect on Markets

Naseem et al. (2021) developed a sentiment index to study the effects of investor psychology on market decisions. The index was built upon PCA (principal component analysis) using individual investor proxies for money flow, relative strength, and turnover assessment compared with daily changes in COVID-19 case numbers and deaths over stock market failures from Chinese, Japanese, and American market indexes. The period covered four months in 2020, and results indicated that investor psychology was negatively associated with stock market returns under psychological resilience. Excessive investor pessimism caused traders to exit the market and lower returns. Additionally, managers tended to exaggerate a firm’s bankruptcy risk based on sentiments during market peaks (Akbar et al. 2021).

Sun et al. (2021) developed an investor sentiment index using PCA and individual proxies reflecting the growth rates of new investor accounts, the discount rate, closed-end fund growth, the turnover rate, and the rate of change in the consumer confidence index for medical stocks in China, Hong Kong, Korea, Japan, and the U.S. The period of analysis was December 2019 to February 2020. They also evaluated the effects of COVID-19 news and macro government news on the sentiment index to gauge their influence on medical stocks and concluded that COVID-19 news and economic announcements did not promote irrational investment behavior in medical stocks. However, economic reports did seem to have greater effects on institutional investor sentiment.

Wang et al. (2021) conducted a study in 2020 of the realized volatility obtained through the variance of stock prices and the fundamental volatility based on information obtained by the decomposition method of Beveridge and Nelson (1981). They developed a metric for expected attention using best-fit regression values for market attention (investor sentiment) relative to COVID-19 news, the number of new COVID-19 cases, and the number of COVID-19 deaths. The residuals were defined as unexpected attention. The expected investor attention was linked to pandemic severity, while unexpected investor attention was associated with factors unrelated to the pandemic. The researchers concluded that expected investor attention affected traders’ attitudes towards both realized and fundamental stock market volatility, whereas unexpected investor attention was primarily related to realized volatility. The connection between expected investor attention and both types of volatility was one-sided, while the link between unexpected investor attention and realized volatility was bidirectional; they claimed that unexpected investor attention was damaging to the stock market.

Chundakkadan and Nedumparambil (2021) found a direct link between investor sentiment as measured by COVID-19-related Google searches, low returns, and high volatility in the stock markets of several countries. Biktimirov et al. (2021) presented evidence that sentiment scores during 2020 were correlated with the intensity of COVID-19 news coverage and strongly associated with S&P 500 index returns. However, sentiment scores inducing polarity (trend) did not influence stock returns.

Van der Wielen and Barrios (2021) determined investor sentiment based on internet word searching and claimed that it was more pronounced in E.U. countries that suffered the most economically. They also concluded that governments’ fiscal measures did not change investor sentiment. Caggiano et al. (2020) reported that COVID-19 caused severe uncertainty in world production, with an estimated cumulative one-year output loss of 14%.

Regarding vaccination, Yu et al. (2021) maintained that the correlation between the anxiety created by reading about COVID-19 cases and deaths, as a proxy for investor sentiment, decreased during periods of enhanced vaccination. Rouatbi et al. (2021) showed that increased vaccination and positive government policy responses decreased stock market volatility, but other factors were also involved. Vaccination rates significantly impacted developed countries more significantly than emerging economies.

Evidence for the relationship between investor sentiment and VIX can be found in the work of John and Li (2021), who constructed individual sentiment proxies with a Google search and divided them into news categories of COVID-19, lockdown, banking, market (negative words in the news), and government support efforts. These sentiment indexes were correlated with the VIX, the S&P 500, and the S&P 500 banks’ index. They concluded that the degree of pessimism among U.S. investors as measured in relation to negative reports on COVID-19 cases, market performance, lockdowns, and banking increased the VIX index. However, only the COVID-19 and market indexes were linked to the increase in realized volatility of the S&P 500 and S&P 500 banks. The index of government efforts decreased the VIX index and the realized volatility of S&P 500 and S&P 500 banks. Bogdan et al. (2021) also confirmed the efficiency of VIX, even during the COVID-19 pandemic period. Regarding VSTOXX, Hachicha et al. (2021) applied the index as a potential inducer of some emerging Islamic stock market hedge factors. Furthermore, Grima et al. (2021) found a cointegration relation between VIX and COVID-19 features, in which new cases had a stronger effect on VIX than new deaths in the U.S. They also found a spillover effect between VIX and other major stock indexes.

3. Findings

Government health, containment, and economic measures were not globally significant in reducing the anxiety of informed investors, as they may have opposite effects on the economy. The outcomes of lockdowns and the increase in government spending may reduce activity and earnings while increasing health spending, taxes, and incentives that promote impulsive activity.

Vaccination generally reduced fear and leveraged the efficiency of government measures in decreasing pessimism, except in Switzerland, which enacted few government measures, and Germany, where there were serious confidence issues about immunization.

Europe and the U.S. showed similar investor reactions to the same triggers of sentiment. Testing, vaccination, and the occurrence of immunity from infection promote investor confidence. Qualified investors in Asian countries revealed a more robust response to government containment measures, compared to Europe and the U.S., mainly due to the traditional compliance features of those countries. Deaths and positive infection rates, when significant, represented a threat to the confidence of informed investors. However, Russian investors showed the opposite behavior in dealing with the positivity rate, which indicates higher risk tolerance towards relative infection; however, a change in absolute case numbers can induce pessimism.

Significant daily changes in mood always produce negativity and distrust in the market. When there is a wide range in investor feelings from optimism to pessimism, it usually results in a lack of market confidence, indicating a tendency on the part of investors to attach more weight to bad news than the opposite. This tendency is a risk-aversion pattern, and investors chose the worst-case scenario before uncertainty.

Combining government measures, vaccination, testing, and the pursuit of immunity is a remedy for reducing fear of investment risk. This combination can help investors, fund managers, and regulators address measures to reduce market instability in pandemic periods. Different regions react differently to pandemic indicators due to cultural, social, and economic characteristics. This work also sheds light on the different triggers of sentiment even among qualified investors who invest in other regions and substantially influence the building of inherent investor sentiment.

Risk perception and risk-taking are not the same among informed investors in different regions due to differences in cultural norms in specific countries and regional idiosyncrasies such as pandemic information, reaction to deaths, cases or testing, vaccination confidence, and attitudes towards lockdowns, healthcare infrastructure, and measures to support businesses. Combinations of these create different assessments at different stages of sentiment that condition investment strategies.

References

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Fama, Eugene F., and Kenneth R. French. 1996a. Multifactor explanations of asset pricing anomalies. The Journal of Finance 51: 55–84.
Fama, Eugene F., and Kenneth R. French. 1996b. The CAPM is wanted, dead or alive. The Journal of Finance 51: 1947–58.
Sharma, Aditya, and Arya Kumar. 2019. A review paper on behavioral finance: Study of emerging trends. Qualitative Research in Financial Markets 12: 137–57.
Verma, Rahul, Hasan Baklaci, and Gokçe Soydemir. 2008. The impact of rational and irrational sentiments of individual and institutional investors on DJIA and S&P500 index returns. Applied Financial Economics 18: 1303–17.
Naseem, Sobia, Muhamed Mohsin, Wang Hui, Geng Liyan, and Kun Penglai. 2021. The investor psychology and stock market behavior during the initial era of COVID-19: A study of China, Japan, and the United States. Frontiers in Psychology 12: 16.
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Wang, Hua, Liao Xu, and Susan Sunila Sharma. 2021. Does investor attention increase stock market volatility during the COVID-19 pandemic? Pacific-Basin Finance Journal 69: 101638.
Beveridge, Stephen, and Charles Nelson. 1981. A new approach to the decomposition of economic time series into permanent and transitory components with particular attention to the measurement of the “business cycle”. Journal of Monetary Economics 7: 151–74.
Chundakkadan, Radeef, and Elizabeth Nedumparambil. 2021. In search of COVID-19 and stock market behavior. Global Finance Journal.
Biktimirov, Ernest N., Tatyana Sokolyk, and Anteneh Ayanso. 2021. Sentiment and hype of business media topics and stock market returns during the COVID-19 pandemic. Journal of Behavioral and Experimental Finance 31: 100542.
Van der Wielen, Wouter, and S. Barrios. 2021. Economic Sentiment during the COVID pandemic: Evidence from search behaviour in the E.U. Journal of Economics and Business 115: 105970.
Caggiano, Giovanni, Efrem Castelnuovo, and Richard Kima. 2020. The global effects of COVID-19-induced uncertainty. Economics Letters 194: 109392.
Yu, X., K. Xiao, and J. Liu. 2021. Dynamic Co-movements of COVID-19 Pandemic Anxieties and Stock Market Returns. Finance Research Letters 46: 102219.
Rouatbi, Wael, Ender Demir, Renatas Kizys, and Adam Zaremba. 2021. Immunizing markets against the pandemic: COVID-19 vaccinations and stock volatility around the world. International Review of Financial Analysis 77: 101819.
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Bogdan, Dima, Ştefana Maria DIMA, and Ioan Roxana. 2021. Remarks on the behaviour of financial market efficiency during the COVID-19 pandemic. The case of VIX. Finance Research Letters 43: 101967.
Hachicha, Nejib, Ahmed Ghorbel, Mohamed Chiheb Feki, Sofiane Tahi, and Fredj Amine Dammak. 2021. Hedging Dow Jones Islamic and conventional emerging market indices with CDS, oil, gold and the VSTOXX: A comparison between DCC, ADCC and GO-GARCH models. Borsa Istanbul Review 22: 209–225.
Grima, Simon, Letife Özdemir, Ercan Özen, and Inna Romānova. 2021. Theinteractions between covid-19 cases in the usa, the vix indexand major stock markets. International Journal of FinancialStudies 9: 26.

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1. Investor Sentiment

2. Investor Sentiment Vis-à-Vis COVID-19’s Effect on Markets

3. Findings

References