Chapter 10: Does Mutual Fund Flow Reflect Investor Sentiment?
10 Does mutual fund flow reflect investor sentiment? Daniel C. Indro Behavioral finance studies routinely challenge the traditional argument that market participants behave rationally (see, e.g., Barber and Odean, 2001; Barberis and Thaler, 2002; Coval and Shumway, 2001; DeBondt and Thaler, 1985; Dreman and Lufkin, 2000; Hirshleifer, 2001; Kahneman and Riepe, 1998; Shefrin and Statman, 1985; Shiller and Pound, 1989; and Shleifer, 2000, among others). In addition, Black (1986) and DeLong et al. (1990) contend that noise traders acting in concert on non-fundamental signals can cause asset prices to deviate from their intrinsic values. However, Shefrin and Statman (1994) offer an appealing alternative explanation of noise traders. Because noise traders do not all commit the same cognitive errors, cognitive biases cause some to be positive feedback traders, and others to be negative feedback traders. As a result, both momentum and contrarian traders may simultaneously participate in the financial markets.1 The mounting evidence that investor trading behavior is driven by behavioral biases has seriously called into question the extent to which arbitrage can eliminate the divergence between prices and fundamental values. Market participants and watchers already seem to believe that sentiment plays a role in the financial markets. A recent Business Week article states: On March 12, the stock market abruptly switched directions and rose 7% in the following three sessions. The powerful rally may have surprised many investors – but certainly not those who believe in sentiment indicators. In the days leading up to the market’s about-face, fans of this contrarian...
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