Investor sentiment, stock returns and idiosyncratic volatility on the Johannesburg Stock Exchange.

Abstract

The convergence of modern finance theory and empirical evidence is explored to identify the impact of idiosyncratic volatility on stock returns. Whilst traditional financial theory indicates that idiosyncratic volatility should not significantly affect stock returns, real-world data indicates that investors often struggle to diversify effectively, rendering idiosyncratic volatility a relevant risk factor. Traders frequently rely on sentiment to gauge short-term price movements driven by investor behaviour. Therefore, this study argues that investor sentiment, which is not usually grounded in fundamentals, plays an important role in explaining idiosyncratic volatility, thereby influencing stock returns. Consequently, the research investigates the intricate relationship between investor sentiment, stock returns and idiosyncratic volatility within the various sectors of the JSE from January 2003 to December 2022. The study used monthly closing stock prices and dividend yield data from sector indices. PCA was used to gauge investor sentiment, incorporating various proxy indicators, including the rand/dollar exchange rate, repo rate, trading volume, volatility index, net migration rate, price of oil and price of gold, collectively providing an estimate of an investor sentiment index. Idiosyncratic volatility was estimated using computed sector and market returns, size, value, profitability and investment factors. To calculate idiosyncratic volatility, the study applied both the CAPM and the Fama and French 3 & 5 Factor models, which collectively generated a comprehensive measure of idiosyncratic volatility for the analysis. The objectives of the study was to develop an idiosyncratic volatility series for each JSE sector index, to determine the relationship between investor sentiment and idiosyncratic volatility across JSE sectors, to examine the impact of idiosyncratic volatility on stock market returns within the JSE sectors and to analyse the relationship between investor sentiment and stock market returns across JSE sectors. Thereafter, the NARDL model was used as the analysis method to achieve the study’s objectives. The study found a significant interplay among investor sentiment, stock returns and idiosyncratic volatility. These key findings highlight a dual relationship for all sectors: firstly, that investor sentiment substantially influences both stock returns and idiosyncratic volatility and secondly, that idiosyncratic volatility exerts a notable impact on stock returns. This underlines the important role of investor sentiment and idiosyncratic volatility as significant risk factors that offer valuable insights for investors seeking to apply valuation models to specific stocks listed on the JSE. Importantly, the quality of financial information distributed by the market and individual firms plays a central role in shaping both investor sentiment and idiosyncratic volatility.