The sentiment represents the anticipations of the investors that are not justified by the
fundamental.
The notion of sentiment characterizes the presence of irrational investors who show undue
interest in an investment opportunity, for example for IPOs, and who are irrationally
exuberant, over optimistic and over enthusiastic about an investment. This over optimism and
over enthusiasm is not justified by fundamental. Or on the contrary, these investors are over
pessimistic and they are much dissuaded about the issues with any reason or relevant
justification. All the decisions are conducted by sentiments and feelings.
An optimistic investor (pessimistic) expects returns that are higher (lower) to those that could
be explained by the fundamental indicators. In other words, the sentiment can be defined by
the fact that the investor is optimistic (pessimistic) without having good (bad) economic
reasons for the being.
The sentiment felt by the investor is very complicated and very hard to surround, since there
are numerous biases that can have an impact on the investor behaviour. The sentiment also
differs from an investor to another, it is individual and can not be foreseen. It depends on the
investor’s personality, his beliefs, his thoughts…
Biases have been studied by psychologists for some time and financial economists have
recently introduced them into formal models of asset pricing. For example, a large literature
reports that people believe their knowledge to be more accurate than it really is (Odean
(1998)), and then they overweight the information collected by themselves and underweight
the information collected by the others. In the same direction, Kaustia and Knupfer (2008) on
a sample of 57 Finnish IPOs from January 1995 through December 2000, study the link
between past personally experienced outcomes and future IPO subscriptions. They find that
personally experienced outcomes have a greater effect on behaviour and on future IPO
subscriptions, than, say just reading about the same information without personal
involvement. When deciding to subscript in IPOs, investors overweight their personal
experience more than the information collected by the other investors, which goes in the same
direction as believing in their knowledge and in their own information.
However, there are other possible reasons for systematic decision errors. In a recent review,
Hirshleifer (2001) argues that many or most familiar psychological biases can be viewed as
outgrowths of heuristic simplification (an imperfect decision making procedure that makes
people have reasonably good decision cheaply). We can also talk about framing effects
(wherein the description of a situation affects judgments and choices), money illusion
(wherein nominal prices affect perceptions), and mental accounting (tracking gains and losses
relative to arbitrary reference points). We also find overconfidence (a tendency to
overestimate ones ability or judgment accuracy) which may be due to another bias “self
attribution”. Experiments have shown that people tend to attribute favourable outcomes to
their abilities and unfavourable ones and failure to chance or other external factors beyond
their control (Daniel, Hirshleifer, and Subrahmanyam (1998)). This bias is known as “self
attribution” and may even be at the origin of “overconfidence”.
This list of biases is not exhaustive and can be very long.
These psychological biases have a great effect on the sentiment, and they also differ from an
investor to another making the sentiment a very complicated notion hard to surround or to
foresee.
The IPO market presents an environment which is more prone to investor sentiment
and where irrational investors are more likely to exist, since IPO firms by definition have no
prior share price history and tend to be young, immature, and relatively informationally
opaque.
Not surprisingly, therefore, these firms are hard to value, and it seems reasonable to assume
that investors will have a wide range of beliefs and feelings about their market values.
Investors will be very influenced by feelings and emotions in valuing the IPO and in deciding
whether to invest in.