3 Investor Sentiment Construction

“Now, the question is no longer, as it was a few decades ago, whether investor sentiment
affects stock prices, but rather how to measure investor sentiment and quantify its effects.”

Malcolm Baker and Jeffrey Wurgler (2007), p.130

What is a good measure of investor sentiment? Several attempts have been made to quantify
investor sentiment and evaluate existing sentiment measures.
In this chapter, different measures of investor sentiment as suggested and discussed in
research as well as used in practice are presented. Different measures can be categorized into
direct measures and indirect measures of investor sentiment.
In an attempt to evaluate different measures of investor sentiment and validate them against
each other, pairwise correlations are computed and compared. This evaluation is based on the
assumption that the measures should somehow move in concert if they are to rest on the same
underlying factor – namely investor sentiment.
This chapter is structured as follows: In section 3.1, related work regarding the classification
of different sentiment measures is presented together with a discussion of their advantages
and disadvantages. Section 3.2 commences with an overview of the most-discussed sentiment
indicator in research, the closed-end funds discount, and also presents recent research
measures. In section 3.3, the most important sentiment measures used in practice are
presented, along with a graphical representation and related findings from research when
available. Section 0 finally compares all measures and discusses how sentiment measures
should be evaluated. Section 3.5 concludes.

3.1. Classification of Sentiment Measures

3.1.1. Related Work
According to Robert J. Shiller, one of the first researchers to study investor expectations and
behavior, most data on investor sentiment refer to simple expectations for price change or
indicators of these expectations (Shiller 2000, p. 49). The problem is that most people do not
have precise expectations for future changes over specific horizons.
Shiller distinguishes two kinds of market sentiment measures: those that are derived from
prices or quantities in markets under a theory relating them to sentiment, and those that are

M. Burghardt, Retail Investor Sentiment and Behavior, DOI 10.1007/ 978-3-8349-6170-9_3,

© Gabler Verlag | Springer Fachmedien Wiesbaden GmbH 2011
36 3 Investor Sentiment Construction

based on polling of investors. The first group of sentiment indices includes the put/call ratio,
the short interest ratio, and the closed-end funds discount (CEFD). In the second group of
indexes, he mentions the survey of the American Association of Individual Investors (AAII),
the University of Michigan Consumer Sentiment Index, and the Investors’ Intelligence (II)
index predicting a correction in market prices.
Brown and Cliff (2004) also identify two basic types of sentiment measures: direct and
indirect sentiment measures. Direct sentiment measures, on the one hand, are created from
surveys that directly measure the sentiment of market participants. They also use the AAII
and the II sentiment measures in their study. Indirect sentiment measures, on the other hand,
are created from financial data and can be categorized, according to Brown and Cliff, into
four groups: indicators based on recent market performance, indicators that relate to particular
types of trading activity, indicators that relate especially to derivatives variables, and other
sentiment proxies that do not fall within one of the above three categories.
Qiu and Welch (2006) also distinguish two measures: Financial measures that are based on
financial data, and survey measures that are based on the polling of investors. In particular,
they examine the closed-end funds discount and the consumer confidence index as two
different proxies for investor sentiment.
Bandopadhyaya and Jones (2006) survey studies that use investor sentiment measures and
classify them into five categories: 1. optimism/pessimism about the economy, 2. optimism/
pessimism about the stock market, 3. riskiness of the stock market, 4. riskiness of an
individual stock, and 5. risk aversion. Their focus is not on how the sentiment measures are
gathered but rather which attitudes are expressed through them.
Beaumont et al. (2005) classify sentiment measures as implicit and explicit, with implicit
measures being constructed from objectively observable financial data and explicit, survey-
based measures that try to capture the mood of the market directly. In addition, they consider
another type of sentiment measure: The combined direct and indirect measure of sentiment
which includes the combination of different indicators and techniques such as those used by
Brown and Cliff (2004) and Baker and Wurgler (2006). They conclude that the integration of
several measures of sentiment has proven a fruitful approach to exploring the relationship of
investor sentiment and stock returns.
In addition to the already mentioned two categories of sentiment (and combinations thereof),
however, there is a third type of measure that is neither based on pure market data nor
investor surveys. This type is referred to as meta-measure. Typically, these measures are
based on an amalgam of opinions.
Recent innovative non-standard methods for sentiment extraction fall into this third category:
Ciccone (2003) uses analyst opinions as a human-level measure of investor sentiment.
Antweiler and Frank (2004) study messages in internet chat rooms focused on stocks and