Idiosyncratic Risk, Stock Returns and Investor Sentiment

Abstract

A growing number of studies show that idiosyncratic risk is positively related to stock returns. However, the results of such works are not consistent with each other. Since the weighting function of prospect theory is not linear, this implies that when investors make decisions under uncertainty they use a dual-classification process. This paper thus argues that applying a more appropriate research method could help to clarify the relationship between idiosyncratic risk and stock returns. This paper applies a Panel Smooth Transition Regression model to conduct an empirical study. The results show that idiosyncratic risk is positively related to stock returns, as is investor sentiment. For a given idiosyncratic risk, retail investors with low sentiment require lower stock returns than investors with high sentiment.