Investor Sentiment and the Low Volatility Anomaly

In this study, we explore one explanation for the ambiguous association between measures of risk and future returns. Drawing on research in psychology, we hypothesize that during periods of high investor sentiment, investors overweight the probability of positive outcomes. Excess demand from overweighting positive outcomes leads to price premiums and subsequent underperformance, especially among the most volatile stocks. Using standard asset pricing methods, we find support for this hypothesis across several measures of risk. We provide additional evidence of our sentiment hypothesis in tests of returns around earnings announcements and using sentiment extracted from messages on social media.