TABLE OF CONTENTS This chapter defines market sentiment, a concept that lies at the core of the book. In finance, sentiment is synonymous with error. This chapter develops a formal definition of market sentiment, and discusses the manner in which the errors of individual investors, particularly representativeness and overconfidence, combine to produce market sentiment.
Notably, the concept of sentiment described here is formally modeled as a stochastic process. In this respect, sentiment is typically time-varying, with random components. One of the key points made in the chapter is that sentiment is best understood as a distribution rather than as a scalar. For example, describing market sentiment as being either only excessively bullish or only excessively bearish can result in an oversimplified characterization.
In January 2000, psychologist Daniel Kahneman gave a presentation at a conference on behavioral finance that was held at Northwestern University. In that talk, Kahneman asked whether it makes sense to speak about the evolution of market prices in terms of a representative investor. Below is an excerpt from his talk.
This talk is meant to be about Psychology and the Market. If you listen to financial analysts on the radio or on TV, you quickly learn that the market has a psychology. Indeed, it has a character. It has thoughts, beliefs, moods, and sometimes stormy emotions.
The main characteristic of the market is extreme nervousness. It is full of hope one...
