Returns, volatility and investor sentiment: Evidence from European stock markets

• We study evolutions in the prices of 46 large-cap stocks listed on European equity markets.
• We integrate the volatility of stock returns in the relationship between market sentiment and future returns.
• We empirically highlight mispricing for the stocks selected according to their volatility and level of investor sentiment.
• We use returns to the mean to generate an “abnormal profit” in stock portfolios.
• We compare the performance of these portfolios with those of reference portfolios.

In this study, we show that patterns in returns behave as if investors, influenced by their level of optimism, selected stocks according to their volatility. Our goal is to confirm the contribution of behavioral finance while showing that investor sentiment can be profitably used by practitioners. We incorporate volatility in the relationship between investor sentiment and future returns, this is the main originality of our approach. Our methodology consists in comparing returns, volatility and higher-order moments of portfolios managed with investor sentiment against those obtained either with passive (buy and hold) portfolio management or with a minimum variance portfolio. Portfolios managed with investor sentiment have better returns and involve less risk under certain conditions.

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