Harbert research finds that individual investors are not the only ones influenced by the overall mood of the financial markets.

Jitka Hilliard, professor in the Department of Finance at Harbert College of Business, co-authored the paper “The role of Market Sentiment in Asset Allocations and Stock Returns,” recently published in the Journal of Behavioral Finance.

The study, which examines how market sentiment influences stock prices, was based on the dissertation research of Shen Zhang, a 2019 Harbert College of Business graduate.  

Hilliard, who chaired Zhang’s Ph.D. committee, said the general wisdom in finance is that sentiment—the overall mood of the market—has a greater effect on the prices of small stocks, and that those stocks are owned mainly by individuals rather than institutional investors. The traditional explanation: Individual investors are perceived to be less knowledgeable and therefore are more likely to be influenced by the swings in market sentiment.

But Hilliard and her co-authors found that market sentiment has the most significant impact on stocks that have high institutional ownership, which are heavily represented in the holdings of mutual funds.

“Though individual investors do react to the market’s mood swings, they hold equity mainly through mutual funds,” Hilliard said. “Therefore, based on their perceived changes in market sentiment, they adjust their mutual fund holdings, not only holdings of individual stocks.

“In times of bullish market sentiment, investors prefer equity funds, but in bearish markets, they allocate more to safer money market funds,” she added. “Buying and selling pressure from mutual funds then affects the prices of the underlying stocks. Since mutual funds hold mainly large and dividend-paying stocks, these stocks become sensitive to swings in market sentiment.”

Sentiment is a branch of behavioral finance that explains anomalous market outcomes by the psychological biases of investors. The study finds that sentiment has a significant effect on stock prices, but the effect is only temporary.

Hilliard’s team aimed to create a sentiment measure that reflects the current market attitude and is relevant mainly to retail investors. Researchers used the Advisor’s Sentiment Report, which publishes results of a survey of more than 100 independent investment newsletters weekly, assigning the mood of each article as bullish, bearish,
or neutral.

“The GameStop saga rocked the markets earlier this year and brought even more attention to the small investor and the gamification of investing,” Hilliard said. “Understanding the behavior of individual investors is
an increasingly important area of current research.”