Mind over market: Impact of investor sentiment on the Indian stock market

Abstract

Investor sentiment influences financial markets beyond fundamental factors. Understanding the extent of this influence on market returns is crucial for stakeholders to make informed decisions. The study analyzed the impact of investor sentiment on the National Stock Exchange (NSE). The investor sentiment index, constructed by extracting sentiments from Times of India business news articles, is used to create the first index, the Financial Index (FinDex), using FinBERT (Financial Bidirectional Encoder Representations from Transformers). The Composite Investor Sentiment Index (CISI), which consists of FinDex and selected sentiment proxy variables, is finally constructed using Principal Component Analysis. This study has analyzed the impact of CISI on selected market indices. Results indicated that stock market returns significantly influence investor sentiment. The broad market index explains 39.12 percent of the variations in CISI. In the sectoral indices, the percentage of variations explained by the sectoral market index is more than 40 percent for auto, realty, and pharma. Investor sentiment also influences stock market returns, but comparatively, the influence is minimal. Thus, sentiment lags behind stock returns rather than driving them. Bidirectional causal relation exists in the case of the auto, public sector bank, and realty sectors (p-value lower than 0.10). CISI can be used by investors to refine their asset allocation strategies, ensuring better market timing and reducing exposure to irrational market swings. It can also be used as an early warning system for systematic risk in financial markets.