Investor sentiment and its role in determining asset prices

It has long been maintained that asset prices are determined by the expectations of, rational investors with unlimited computational capacity thus precluding any predictability of asset returns. The past decades have, however, witnessed an increasing amount of evidence on (persistent) mispricing and, thus, predictability of asset returns for the U.S. Mispricing is believed to be caused by irrational beliefs of the part of the investment community made up of retail investors (investor sentiment). To give content to it behavioral economists have put forth a number of psychological factors (such as overconfidence and representativeness) that nicely fit into observed patterns of behavior. Swings in such factors and, thus, in sentiment can drive asset prices away from fundamental values and lead to inefficiency on the capital markets. The aim of our research project is to contribute to the understanding of investor sentiment and its influence on asset prices in Germany.  One distinctive feature of the German stock market is that it is a predominantly institutional market, so that investor sentiment is not expected to exert high influence on asset prices.  Delineating the role of investor sentiment in driving asset returns is of utmost importance in furthering the research community s understanding of price dynamics and strengthening the stability of the financial system.