CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Stock market prices both in developed and emerging countries are generally believed to be responsive to economic and market fundamentals or new information. The event of 2008/2009 market crashwhich led to a wide deviation of stock prices from their fundamental value is generating questions and drawing attention to finding out if non-market and non-economic fundamentals are responsible for such deviations. The determination of equity price movement in most emerging stock markets has been discussed by scholars and researchers from the perspective of market, economic and firm-specific fundamentals.However, there has been some kind of shift in the discussion of equity price movement to favouringinvestors‘ sentiment/emotions. Investors‘ sentiment in general term refers to the attitude, emotions and biases that exhibit in the course of investment decision. Baek, Bandopadhaya and Du (2005) studies revealed that most short-term movements in asset prices such as equity are best explained by investors‘ sentiment. Similarly, Fisher and Stantunan (2000)are also of the view that investors‘ sentiment matter to asset pricing process.
Thus, in the pricing of equities and other financial assets, investors‘ attitude is of major concern for financial analyst and it is seen as a key determinant of the value of most financial assets (Huiwen, 2012). Baker and Wurgler (2006) recognized investors‘ psychology as a vital component in market pricing process of financial assets. This is because the sentiment of investors‘ may also reflect their risk profile and investors‘ emotion are displayed in different forms. In behavioural finance, emphasis is placed on investors‘ sentiment/bias such as escalation, cognitive dissonance and overconfidence bias. Escalation bias tend to exist when an investor continue to purchase a poor performing stock with the notion that the stock poor performance is temporary, this single act of investors‘ can influence the price of the stock in question positively since the investors‘ are not selling even when bad news enter into the market. In the case of cognitive dissonance the investors‘ act only when market information conforms to his belief.
This therefore means that equity price moves only when the investors‘ interpretation of an event negates the market news. Shefrin and Statman (1996) stressed that prices of equities and other financial assets are determined by the level of confidence investors‘ have on the growth of a company. The investor commits overconfidence bias when he/she overestimates the growth rate of a company and concentrates on good news and this has great influence to the determination of financial assets prices. In some studies, findings of sentiment and stock returns relationship are not in accordance with the Efficient Market Hypothesis. Fama (1970)stressed that the stock prices reflect the discounted value of expected cash-flows and the effect of irrational market participants in stock prices are removed by the rational participants.
However, behavioural finance experts such as Chang, Ma, Chiu, Lin and Lee (2009a), suggest that irrational sentiment (overly optimistic/pessimistic expectations about investment risk and future cash flow) can persist and affect stock prices for significant periods of time. On the contrary, Baker and Wurgler (2006) state that stock mispricing is based on uninformed demand shocks induced by irrational investors‘ and limits to arbitrage. Brown and Cliff (2005) claim that sentiment could be a very persistent effect so, the demand shocks of irrational traders could be correlated over time leading to a strong and persistent mispricing.
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EFFECT OF INVESTORS‘ SENTIMENT ON STOCK MARKET RETURNS IN NIGERIA
