Rational Approach to Noise Trader Approach in Asset Pricing: A Review

Abstract

Neoclassical finance assumes investors are rational and the markets reflect the fundamental value of its assets. Behavioural finance assumes there are noise traders in the market and their sentiment effect asset prices. However investor sentiment is an elusive concept [1]. Therefore this study explores the concept of investor sentiment through the noise trader approach in asset pricing. It identifies investor sentiment as the irrational investors’ erroneous beliefs about future cash flow relative to the intrinsic value of the underlying asset. It considers how an exogenous shock in investor sentiment effect investors’ beliefs and how it is captured through survey measures. Further it reviews the behavioural argument underlying closed end fund puzzle, liquidity, new issue puzzle and dividend premium as measures of investor sentiment. Finally it lays groundwork for a composite sentiment index for the frontier market Sri Lanka.