The Effect of Investor Sentiment on Stock Returns: Evidence from a Frontier Market

Abstract

The conventional theory of finance considers that investors are rational and make informed investment decisions and any change in pertinent risk is expected to be the result of changes in fundamental factors. Nonetheless, the sentiment-return association strongly contradicts the hypothesis of an efficient market. This study is based on the theory of behavioural finance which explores the impact of investor sentiment on the yearly stock returns of 141 companies listed on the Dhaka Stock Exchange (DSE) from July 2017 to June 2021. Two distinct sentiment dimensions are analysed, stock-specific investor sentiment, measured by the log difference of stocks’ trade volume and market-wide sentiment, measured by the log difference of the DSEX index. The regression model includes firm characteristics variables: firm size (SIZE), price-to-NAV ratio (PNAV), sale growth (SG), and Earning Per Share (EPS) as well as macroeconomic control variables: inflation rate (INF) and short-term interest rate (INT). By employing a cluster random effect regression model, it is observed that stock-specific investor sentiment has a significant positive influence on stock returns, in contrast, market-wide sentiment does not have any significant effect. Moreover, stock- specific investor sentiment’s effect on stock returns persists even after controlling for macroeconomic factors across SIZE, PNAV, or SG in the DSE. Hence, the empirical outcomes imply that the optimistic sentiment of the investors significantly increases the stock returns whereas the pessimistic sentiment of the investors has a reverse impact.