Generally, investor sentiment is a concept that describes the general mood of investors. It can be used to gauge how investors are reacting to current and future price movements of securities. There are several ways to measure sentiment. It is not an exact science. But it can provide a useful guide for analyzing pricing puzzles for difficult to value securities.
The most important effect of investor sentiment is that it can affect the price of stocks. Investors who feel good about a company or a stock tend to invest more heavily in it, and thus, drive its price up. This is why it’s common to hear terms such as a ‘bull market’ or a ‘bear market’.
However, there’s also a downside to investor sentiment. When prices start to fall, sentiment turns negative. Pessimism can drag prices down too far, and busts can follow. This makes it difficult to value stocks, particularly for small firms.
Optimism and pessimism are two opposite emotions that have a strong relationship with the price of securities. When an investor is optimistic, he or she overestimates the future payoffs of an asset. When the sentiment is negative, the investor is pessimistic and tends to undervalue stocks.
Investor sentiment can also affect the valuation of new companies, especially those that are expected to grow rapidly. This is because the present value of expected cash flows determines the value of securities. However, there are limits to the ability of sophisticated investors to adjust for overvaluations.
