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A Principal Component Approach for Measuring Investor Sentiment

Abstract

Main objective of this study is to understand the sentiment effect in Sri Lankan market while developing an aggregate investor sentiment index. Even with a rich literature on the subject matter, it was understood that empirical findings relevant to Sri Lankan market are minimum. Given this context, current study attempts to test the sentiment effect over a sample period of 96 months, based on all the listed entities at Colombo Stock Exchange. The results suggest existence of sentiment at a marginal level. Upon a comprehensive analysis of number of different sentiment indicators, the study suggests four measures based on extant literature and expert advice. This paper develops a comprehensive index to measure the sentiment of the Colombo stock exchange. The index is a linear combination of four sentiment proxies whose weights are obtained via the principal component method. The study promotes sentiment-based trading rules, which are known to be profitable. The results in this paper provide useful information for investors, business-cycle researchers and academics.

Keywords— Investor sentiment, Principal Component Analysis, Asset pricing

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