Volatility, Sentiment, and Noise Traders

The most basic implication of noise-trader theory is that irrational investors acting coherently on a noisy signal can cause systematic risk. If noise traders affect prices, the noisy signal is sentiment, and the risk they cause is volatility, then sentiment should be correlated with volatility. This article shows that, in fact, unusual levels of individual investor sentiment are associated with greater volatility of closed-end investment funds. Furthermore, this volatility occurs only when the market is open and is associated with heightened trading activity. It persists after controlling for marketwide volatility and changes in fund discounts.