Predictability of Investor Sentiment of “Low- volatility Anomaly” in Distinct Market States
Author
Abstract
A “low volatility anomaly”, namely, a high-risk stock with a low return, runs counter to fundamental principles in which risk is compensated by a higher expected return. Behavioral theory explains that individual investors prefer stocks with lottery-like payoffs, leading to increases in demand for higher-volatility stocks. We hypothesized that the risk-adjusted returns of higher-volatility stocks (lottery-like stocks) should be more profitable in periods of high sentiment than in periods of low sentiment. Furthermore, this paper investigated whether investor sentiment predicts profit in low-volatility strategy and whether investor sentiment is more predictable in an expansion state. Specifically, we show that the lowvolatility anomaly exists, and stocks with greater volatility are more profitable following high investor sentiment levels. Moreover, we demonstrate that investor sentiment can predict profit in the low-volatility strategy and show that investor sentiment only has predictive power for low-volatility anomaly in the expansion state. Consequently, these results provide further evidence that investor optimism increases preferences for lottery-type stocks; as a result, individual investors demand higher volatility stocks more frequently in the expansion state.
Key Words
Low volatility anomaly, Investor sentiment, Preferences for lottery-type stocks, Market states
