Value at Risk, Cross-sectional Returns and the Role of Investor Sentiment, a paper co-authored our school’s Assistant Professor Zhu Yifeng, and PhD student Bi Jia under the Tilburg Program, was officially published as the lead article in the 2020 56th Volume of Journal of Empirical Finance, a prestigious journal on finance.
By analyzing data about listed companies in the US stock market over a period of more than 50 years, this paper finds that value-at-risk (VaR) has a negative relationship with cross-sectional expected returns on stocks, and such relationship can be explained by volatility of the US market. It provides a new perspective on looking at the relationship between financial risks and cross-sectional expected returns, and finds that at different investor sentiment levels, VaR shows completely different prediction capabilities for cross-sectional expected returns.
The main contributions made the paper includes: First, it uses investor sentiment as a key indicator to measure different research subjects. By dividing overall data into two categories - high and low investor sentiments, it finds that the relationship between VaR and cross-sectional expected returns performs completely differently at different investor sentiment levels. It provides a broader way of thinking on the integrated development of psychology and finance, and finds that VaR is negatively correlated with cross-sectional expected returns during a high investor sentiment period, which cannot be explained by momentum, short-term reversal, volatility or financial distress. But in a low investor sentiment period, such relationship will disappear, with no obvious correlation between the two. Second, these empirical results support the prospect theory, which holds that when fully confident, investors will show their risk preferences and are willing to hold high-risk assets. Meanwhile, such finding offers some lessons to the industry, as well as a profitable trading strategy. It is about dividing stocks with different investor sentiment levels into different groups, short-selling the group with the highest investor sentiment, and going long on the group with the lowest investor sentiment; then updating portfolios each month based on investor sentiments to obtain a handsome profit. Third, it is also found through research that such a negative relationship is shown more intensively in stocks where individual investors account for a high percentage, which indicates that institutional investors are less susceptible to sentiment than individual investors. This is of some guiding and instructive significance to the institutionalization and “deretailization” of the securities markets.