Investor Sentiment, Beta, and the Cost of Equity Capital

The security market line (SML) accords with the capital asset pricing model (CAPM) by taking on an upward slope in pessimistic sentiment periods, but is downward sloping during optimistic periods. We hypothesize that this finding obtains because periods of optimism attract equity investment by unsophisticated, overconfident, traders in risky opportunities (high beta stocks), while such traders stay along the sidelines during pessimistic periods. Thus, high beta stocks become overpriced in optimistic periods, but during pessimistic periods, noise trading is reduced, so that traditional beta pricing prevails. Unconditional on sentiment, these effects offset each other. While rational explanations cannot completely be ruled out, analyses using earnings expectations, fund flows, the probability of informed trading, and order imbalances do provide evidence that noise traders are more bullish about high beta stocks when sentiment is optimistic, while investor behavior appears to accord more closely with rationality during pessimistic periods, supporting our hypothesis. * Antoniou, [email protected], Warwick Business School, University of Warwick, Gibbet Hill Road, Coventry, CV4 7AL, U.K., Tel: 44-(1392) 726256. Doukas, [email protected], Old Dominion University, Strome College of Business, Constant Hall, Suite 2080, Norfolk, VA 23529-0222, Tel: 1(757) 683-5521, and Judge Business School, University of Cambridge, U.K. Subrahmanyam (corresponding author), [email protected], Nanjing University School of Management and Engineering, and the Anderson School, University of California, Los Angeles, CA 90095-1481, Tel: 1(310) 825-5355. We are grateful to Wei Jiang (the editor), an anonymous Associate Editor, and two anonymous referees, for their insightful and constructive feedback. We also thank Malcolm Baker, Peter DaDalt, Pasquale Della Corte, Arie Gozluklu, Tony Hewitt, Rustam Ibragimov, Roman Kozhan, Yul Lee, Anthony Neuberger, Vikas Raman, Raghu Rau, Richard Taffler, Julian Xu, Pedro Saffi, James Sefton, Katrin Tinn, Tong Yu, Paolo Zaffaroni, and seminar participants at the University of Cambridge, Center of Planning and Economic Research (Athens, Greece), Imperial College, University of Reading, University of Rhode Island, and the University of Warwick for useful comments and suggestions.