On Individual and Institutional Noise Trading

Previous research suggests that individual investor sentiment has incremental explanatory power for returns of small cap stocks, value stocks, stocks with low institutional ownership, and stocks with lower prices (Kumar and Lee (2003)) and that there is a strong link between institutional sentiment and the returns of large stocks (Brown and Cliff (2004)). With respect to return volatility, Jackson (2003a,b) found that larger trading share of individuals in certain stocks does not increase their subsequent volatility; however, the opposite is true for institutional participation, which increases conditional volatility. We propose an integrated framework that jointly tests for the effects of individual as well as institutional sentiment on return and volatility. Using implicit measures of sentiment for the German stock market over the period 02/2000 until 04/2005, our results suggest that institutional sentiment has only minor incremental explanatory power for returns and conditional volatility of large cap stocks, but we find strong evidence that individual sentiment is the important market-wide risk factor and does affect the return and conditional volatility of large as well as small cap stocks. JEL Codes: C22, D82.