Investor Sentiment and the Mean–Variance Relation

Journal of Financial Economics 100 (2011) 367–381

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Journal of Financial Economics

journal homepage: www.elsevier.com/locate/jfec

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Jianfeng Yu a,1, Yu Yuan b,c,Ã

a

University of Minnesota, 321 19th Avenue South, Suite 3-122, Minneapolis, MN 55455, United States University of Iowa, United States c The Wharton School, University of Pennsylvania, 3620 Locust Walk Suite 2300, Philadelphia, PA 19104, United States

b

a r t i c l e in f o

Article history: Received 16 January 2009 Received in revised form 28 January 2010 Accepted 17 February 2010 Available online 21 October 2010 JEL classification: G12 G14 G17 Keywords: Investor sentiment Mean-variance relation Risk-return tradeoff Volatility

abstract

This study shows the influence of investor sentiment on the market’s mean–variance tradeoff. We find that the stock market’s expected excess return is positively related to the market’s conditional variance in low-sentiment periods but unrelated to variance in highsentiment periods. These findings are consistent with sentiment traders who, during the high-sentiment periods, undermine an otherwise positive mean–variance tradeoff. We also find that the negative correlation between returns and contemporaneous volatility innovations is much stronger in the low-sentiment periods. The latter result is consistent with the stronger positive ex ante relation during such periods. & 2010 Elsevier B.V. All rights reserved.

1. Introduction Theories of rational asset pricing typically imply a positive relation over time between the market’s expected

$ We are very grateful to Joao Gomes, Craig MacKinlay, Rob Stambaugh, and Geoff Tate for their invaluable support and comments. We would like to thank an anonymous referee, Andy Abel, Elena Asparouhova, Marshall Blume, Frank Diebold, Jack Fan, Jingyang Li, Marcelo Maia, Stavros Panageas, William Schwert, Moto Yogo, Weina Zhang, Paul Zurek, and seminar participants at China...