Measuring investor sentiment and behaviour to gauge financial risk

Abstract

Whether financial markets are governed by rational forces or emotional responses has long been debated. The spectacular rise of commodity futures prices and the current plunge in value stocks have intensified the debate, highlighting that implied volatility is not an accurate measure of market risk. Asset managers traditionally assume irrational investor behaviour when creating and administering portfolios but this is hindered by a lack of diagnostic tools. In particular, they are unable to adapt to emotional and moderate cognitive biases at high wealth levels to modify investor behaviour at lower wealth levels. Henceforth, practitioners should rely on specific quantitative guidelines when modifying asset allocations to account for biased behaviour. As a result, specific quantitative guidelines must be followed when modifying asset allocations to account for biased behaviour. This paper proposes a framework for better understanding how behavioural finance can be associated with a classical approach in many areas of investing, including valuation. The paper will discuss key behavioural phenomena, notably market sentiment and noise trading, integrated as parameters in a new quantitative risk–return calculation. This comprehensive model will suggest acceptable discretionary distances from the mean–variance output for determining the best practical allocation. Finally, the paper compares the returns of so-called ‘behavioural mean–variance portfolios’ with those of traditional mean–variance-efficient portfolios.