Investigating the Asymmetric Relationship between Investor Sentiments and Fluctuations in the Overall Index via the Markov Switching Method

Document Type : Research Paper


1 Assistant Prof., Department of Banking Management, Faculty of Management and Accounting, South Tehran Branch, Islamic Azad University, Tehran, Iran.

2 MSc., Department of Financial Engineering and Management, Irshad Damavand Institute of Higher Education, Tehran, Iran.

3 PhD. Department of Financial Engineering, Faculty of Management and Economics, Research Science Branch, Islamic Azad University, Tehran, Iran.


Behavioral finance research delves into how investors' perceptions of the capital market and the decisions they make are influenced by psychological factors, ideas, and their willingness to take risks. In addition, it tries to identify the investors’ decisions by investigating the psychological factors. The researchers have tried for several decades to explore the direct relationship between the sentiments and total index return by linear methods permanently. However, this research examines the asymmetrical relationship between investors' sentiments and fluctuations in the total index, categorized into recession and boom regimes. Generating instantaneous response functions based on regimes enables a comprehensive investigation of how investors' sentiments impact market fluctuations in distinct market conditions. Investors' perceptions of total index fluctuations revealed significant losses during various periods of market collapse. Consequently, this study explores the connection between the total index's behavior and investors' sentiments.
Four criteria were used in this research to assess the sentiments indirectly. First, the sentiments hybrid index was extracted in the 2011-2021 period using the main components analysis method. Then, the non-linear Markov switching model was used to investigate the asymmetric relationship between investors' sentiments and total index returns and fluctuations. Moreover, instantaneous response functions were used to investigate the effect of shocks on each research variable. Eviews12 and OxMetrics8 software types were used to estimate the research model.
The findings affirm the presence of an asymmetric relationship between investors' sentiments, returns, and total index fluctuations during both recession and boom periods. Investors' reactions to market fluctuations were found to be positive and significant during the upward market trend of the capital market. However, investors' reactions to market fluctuations were negative during the downward market trend. Furthermore, the study revealed that an increase in returns during a bearish market trend elicited a negative response from investors, while in an upward market trend, it triggered a positive reaction. Moreover, extraction results of instantaneous response functions showed that the inserted shocks to the variables in recession and boom periods may lead to different reactions.
As per the research findings, the likelihood of market continuity stands at 41.54% during the boom regime and 58.46% during the recession regime. This shows the fact that the capital market's tendency to persist in the recession period is higher. Moreover, an examination of the derived instantaneous response functions from the model revealed that sentiment shocks can substantially alter stock market returns. The nature of these effects may vary depending on the prevailing market conditions (be it during a recession or a boom). The outcomes of this study enhance the understanding of investors and decision-making institutions regarding the impact of investor sentiments on capital market fluctuations and returns. This insight empowers decision-makers to formulate policies aimed at managing the impact of influential news and rumors, ultimately leading to heightened investor awareness and a reduction in market volatility.


Main Subjects

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