Unfollowing the Crowd: Investor Sentiment Causes Higher Volatility

Which influential investors should diligent equity investors follow? Should you be following anybody? Recent evidence reviewed by CFA Digest’s abstractors suggests chasing noise helps amplify sentiment shocks, moving stock prices away from fundamental values.

Tracking social media was once thought to be a promising investment strategy — Twitter users can simultaneously follow hundreds of prominent investors — yet recent studies are not encouraging. Investor sentiment actually seems to cause higher volatility and short-lived stock price movements, not least due to investor relations (IR) firms spinning their client’s stories.

Perhaps one shortcut to success might be to pick out a couple of superstar investors, or to study the all-time great investors from history. This is not as simple as it sounds. Recent research suggests Warren Buffett’s investment acumen at Berkshire Hathaway (BRK.A) can be ascribed to purchasing low-beta stocks with substantial leverage funded at an interest rate cost below that of US Treasury securities — which can’t be easily replicated by the rest of us. Influential economist John Maynard Keynes was also a star investor in the 1930s, but the ducks seem to be lined up very differently today for would-be imitators. Jim Cramer’s recommendations on CNBC’s Mad Money may affect the price of the stocks he recommends, but only for a short period; so catch it if you can.

In both the short and long run, investor sentiment and stock prices embody many unresolved uncertainties over time. Luboš Pástor and Robert F. Stambaugh suggest that rather than reverting to the mean, stock return volatility (as measured by “predictive variance”) is actually higher over long periods than short periods from an investor’s perspective. The future is by definition uncertain, so there is no guaranteed escape from stock price volatility other than more effective overall portfolio diversification strategies.

For more reading on investor sentiment, see:

• Chasing Noise: Focusing on the interaction among different types of investors in a market, the authors present a simple model in which rational but uninformed traders occasionally chase noise as if it were information, thereby amplifying sentiment shocks and moving prices away from fundamental values.
• Tracking Social Media: The Mood of the Market: The results of natural language processing of social media output are increasingly being packaged and sold to hedge fund managers. But can sentiment factors improve performance?
• How Mad Is Mad Money? Jim Cramer as a Stock Picker and Portfolio Manager: Jim Cramer’s recommendations affect the price of the stocks he recommends, but only for a short period. Cramer fails to deliver statistically significant alpha, and evidence suggests that Cramer joins the herd when he makes his recommendations.
• Keynes the Stock Market Investor: Influential economist John Maynard Keynes is reputed to also have been a star investor. To test this hypothesis, the authors apply a range of modern quantitative and qualitative techniques to a dataset of Keynes’s investments.
• The Secrets of Buffett’s Success: Beating the Market with Beta: Warren Buffett’s investment acumen can be ascribed to purchasing low-beta stocks with substantial leverage at a cost of funding below that of US Treasury securities over the period under consideration.
• Are Stocks Really Less Volatile in the Long Run? Stock returns are uncertain. Traditionally, annualized return volatility is understood to decrease over long periods because of mean reversion. In contrast, the authors find that from an investor’s perspective, stocks are more volatile over long periods because of parameter uncertainty.
• Selective Publicity and Stock Prices: Investor relations (IR) firms “spin” their corporate client news, generating more media coverage of positive press releases than of negative press releases, which increases returns during non-earnings announcements.
• How Important Is the Financial Media in Global Markets? Stock returns in developed markets display greater volatility related to a typical news story than those in emerging markets.
• The Short of It: Investor Sentiment and Anomalies: The authors study the role of investor sentiment in explaining equity market anomalies in cross-sectional stock returns. Sentiment affects equity anomalies differently in a shorting strategy than in a long strategy.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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