BPEA | 1990 No. 2

The Stock Market and Investment: Is the Market a Sideshow?

1990, No. 2

RECENT EVENTS and research findings increasingly suggest that the stock market is not driven solely by news about fundamentals. There seem to be good theoretical as well as empirical reasons to believe that investor sentiment, also referred to as fads and fashions, affects stock prices. By investor sentiment we mean beliefs held by some investors that cannot be rationally justified. Such investors are sometimes referred to as noise traders. To affect prices, these less-than-rational beliefs have to be correlated across noise traders, otherwise trades based on mistaken judgments would cancel out. When investor sentiment affects the demand of enough investors, security prices diverge from fundamental values.