Abstract:
Neoclassical finance assumes investors are
rational and the markets reflect the fundamental value of its
assets. Behavioural finance assumes there are noise traders in
the market and their sentiment effect asset prices. However
investor sentiment is an elusive concept [1]. Therefore this
study explores the concept of investor sentiment through the
noise trader approach in asset pricing. It identifies investor
sentiment as the irrational investors’ erroneous beliefs about
future cash flow relative to the intrinsic value of the underlying
asset. It considers how an exogenous shock in investor
sentiment effect investors’ beliefs and how it is captured
through survey measures. Further it reviews the behavioural
argument underlying closed end fund puzzle, liquidity, new
issue puzzle and dividend premium as measures of investor
sentiment. Finally it lays groundwork for a composite
sentiment index for the frontier market Sri Lanka.
