Research on the Effect of Firm-Specific Investor Sentiment on Idiosyncratic Volatility Anomaly : Evidence from the Chinese Market

This paper evaluates how investor sentiment contributes to the explanation of idiosyncratic volatility from a firm-level perspective in the Chinese stock market. After constructing a comprehensive firm-specific investor sentiment (FSIS) index using principal component analysis, we find a positive relationship between firm-specific investor sentiment and idiosyncratic volatility. Meanwhile, we also examine the variational and persistent effects of firm-specific investor sentiment. The empirical results show that a rising (decreasing) FSIS effectively strengthens (eliminates) the idiosyncratic volatility anomaly, demonstrating that investor sentiment has a significant impact on earnings anomalies. More critically, we explore the mechanisms by which firm-specific investor sentiment affects idiosyncratic volatility from the gambling behavior (MAX effect) and limits-of-arbitrage, and we find that stocks with high investor sentiment exhibit notable lottery-type and arbitrage constraints that cause the idiosyncratic volatility anomaly. Finally, Our analysis also serves as a reminder to regulators to pay more attention to stocks with high investor sentiment and helps retail investors minimize losses by constructing their portfolios based on investor sentiment