Market Sentiment: A Tragedy of the Commons

A prominent idea in behavioral …nance is that individuals have some propensity to make correlated mistakes in their investment decisions. The leading critique of this idea is that investors who make systematic mistakes su¤er a utility cost and should be expected to alter their behavior. In this paper we present a noisy rational expectations model in which investors decide whether or to what degree they want to allow their behavior to be in‡uenced by “market sentiment”, which we de…ne as a bias in individual beliefs about future payo¤s. Investors who choose to insulate their decision from market sentiment earn higher expected returns, but incur a small mental cost. (It requires some concentration to insulate oneself from the moods of others.) We show that if information is moderately dispersed across investors, even a very small mental cost (on the order of 0:001% of consumption) may generate a signi…cant amount of sentiment in equilibrium: Individuals who choose to be swayed by sentiment increase uncertainty about the future and make it less costly for others to be swayed by sentiment as well. Market sentiment thus emerges as a tragedy of the commons. In related work, (Tarek A. Hassan and Thomas M. Mertens 2010), we show that even moderate amounts of this kind of sentiment may result in a large rise in the …nancial risk faced by investors.