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Rational or irrational investor sentiment: Evidence from China

Changsheng Hu, Wei Sun, Yangchun Chi

In this paper, we make a doubt to the currently widely used sentiment index construction method proposed by Baker and Wurgler (2006). After analyzing its prerequisites, we put forward a new methodology for distinguishing between rational and irrational sentiment based on the idea of extracting common factors. In contrast to previous studies, we redefine the concept of "rationality" from the perspective of investors’ pursuit for wealth maximization instead of associating it with fundamentals. Thus, rational sentiment reflects "smart money", while irrational sentiment reflects "dumb money". Finally, we conduct a comparative analysis of 15 commonly used single sentiment proxies. The empirical results support our predictions.