Investor Sentiment, Behavioral Heterogeneity and Stock Market Dynamics

Recent empirical works corroborate importance of sentiment in asset pricing. We further propose that sentiment may not affect everyone in a homogeneous way. In this paper, we construct a sentiment indicator taking into consideration behavioral heterogeneity of interacting investors. From our model simulation, we find sentiment contributes to several financial anomalies such as fat tails and volatility clustering of returns. More importantly, investor sentiment could be a significant source of financial market volatility. Our model with sentiment is also able to replicate different types of crises. Our finding shows that severity of crisis intensifies with investors’ sentiment sensitivity.