Is sentiment the solution to the risk–return puzzle? A (cautionary) note

The risk–return relationship in stock markets is often found to be negative or non-existent, in contrast with fundamental finance theories. In this note we investigate if one proposed solution to this puzzle, which states that high irrational investor sentiment disrupts the otherwise positive risk–return nexus, is robust across popular sentiment proxies and therefore empirically comprehensively validated. We find that it is not robust, as most individual sentiment proxies fail to support the hypothesised negative impact of sentiment on the risk–return relationship. Only when a common component of individual proxies is extracted to form a single sentiment measure do we find robust support for the notion that high sentiment impedes rational asset pricing.