Investor Sentiment and Stock Market Volatility in India: A Psychological and Empirical Analysis of Investment Strategies

 

Shubham Prafulkumar Chavhan ¹, Dr. Vinod Waiker ²

 

¹ Research Scholar, Datta Meghe Institute of Management Studies, Nagpur, Maharashtra, India

² Research Supervisor, Datta Meghe Institute of Management Studies, Nagpur, Maharashtra, India

 

1.  INTRODUCTION

Investor sentiment, which is characterised as their overall perspective on a certain asset or financial market, is a significant factor in the development of stock market volatility and performance dynamics. Investor sentiment has emerged as a critical element impacting both individual action prices and overall market movements in the fast changing Indian financial scene. Due to its distinct features, including its growing number of retail investors, socioeconomic diversity, and varying levels of market literacy, the Indian market does not recognise the need of comprehending investor behaviour as a crucial component of financial research Ph and Rishad (2020).

This research document aims to analyze the complex relationship between the feeling of investors and market volatility within India, integrating relevant psychological theories alongside empirical data. The objective is to elucidate how fluctuations in investor feeling can lead to significant market volatility and to assess the implications of this volatility for various investment strategies. By relying on established psychological theories, such as the behavioral financing paradigm, which highlights psychological biases influencing decision -making - this research strives to provide complete information on the behavioral aspects of investors and their effects on market results.

The importance of investors feeling is underlined by the concept of breeding behavior, where investors tend to follow the majority choices rather than counting on their independent analysis. This trend can lead to sudden price movements, as seen during booms and market busts. In the Indian context, where the market has witnessed several cases of net corrections and rallies over relatively short periods, the phenomenon of farming has a critical exploration area. Empirical data will be used to demonstrate the correlation between commercial activity focused on the resulting market and volatility, based on measures such as volatility index (VIX) and sector performance during periods of increased feeling.

In addition, the work of Chakraborty and Subramaniam (2020) sheds light on the role of the indicators of the sentiment, such as the Indian Vix, which measures the volatility of the market and the investigations of investors who evaluate the levels of feeling, as tools to understand fluctuations in market behavior. Their empirical analysis shows a strong correlation between the feeling of negative investors and greater volatility, in particular during periods of economic uncertainty. This link underlines the need to consider psychological factors when evaluating market trends and investment strategies are devised. The researchers affirm that the periods identified by the high volatility often coincide with peaks in the negative feeling, leading to the phenomenon of market corrections that differ substantially from intrinsic values.

 

1.1.    Objective

·        To examine the psychological factors influencing investor sentiment and analyze their impact on stock market volatility in the Indian context.

·        To empirically evaluate the relationship between investor sentiment indicators and market performance

 

2. Review of Literature

The relationship between investor sentiment and stock market volatility has been a focal point of financial and behavioral economics over the years. Several studies have explored how psychological biases, mood, media, and market noise affect investment behavior and price movements.

Baker and Wurgler (2006) were pioneers in empirically establishing the link between investor sentiment and stock returns. They developed a sentiment index and found that sentiment has a stronger effect on stocks that are difficult to value and arbitrage, such as small-cap and high-growth stocks.

In the Indian context, Rao and Prabheesh (2008) examined the dynamic interactions between investor sentiment and stock market returns using Granger causality tests. Their findings indicated a bidirectional causal relationship, suggesting that sentiment influences market movements and vice versa.

Shiller (2000) in his work Irrational Exuberance, emphasized how psychological factors and herd behavior lead to market bubbles and crashes. His analysis provides a theoretical underpinning to the study of investor sentiment influencing volatility, particularly during speculative episodes.

De Long et al.  (1990) proposed a noise trader model to explain how irrational investors, driven by sentiment, can create price movements unrelated to fundamentals, resulting in excess volatility. Their work laid the groundwork for sentiment-driven asset pricing models.

Dash and Mahakud (2013) constructed an investor sentiment index for India using principal component analysis and investigated its predictive power for stock market returns. Their study revealed a significant relationship between sentiment and short-term market fluctuations.

Brown and Cliff (2004) provided a comprehensive empirical analysis of investor sentiment using survey-based and market-based proxies. They concluded that sentiment is a significant determinant of market returns, especially during periods of market stress.

Chopra et al. (1992) studied overreaction and found that investors often overreact to both good and bad news, leading to excessive volatility. Their findings support the behavioral theory that sentiment-driven trading can deviate prices from intrinsic values.

Kumar and Lee (2006) developed a novel method for measuring sentiment using trading imbalances of retail investors. Their results showed that sentiment has a persistent effect on cross-sectional stock returns, especially for stocks with high retail investor interest.

In India, Sinha (2010) conducted an empirical investigation of the Bombay Stock Exchange (BSE) and found that sentiment indicators like market turnover ratio, mutual fund flows, and media coverage significantly impact stock market volatility.

 

3.  Research Methodology

The present study adopts a descriptive research design aimed at understanding the psychological and empirical aspects of investor sentiment and its relationship with stock market volatility in India. To gather primary data, a structured questionnaire was developed and administered to investors, focusing on their perceptions, behavioral patterns, and investment strategies in relation to market fluctuations. The data was collected using the questionnaire method, ensuring uniformity and consistency in responses. A total of 100 respondents participated in the study, selected through a convenient sampling technique, which allowed the researcher to collect data efficiently from readily available and willing participants. This methodological approach enabled a comprehensive analysis of investor behavior within the current Indian stock market context.

 

4.  Data Analysis and Interpretation

To understand the psychological factors affecting investor sentiment, respondents were asked to rank the importance of various psychological influences such as herd behavior, overconfidence, risk aversion, market rumors, and media influence on a 5-point Likert scale.

Psychological Factor	Mean Score	Standard Deviation
Herd Behavior	4.2	0.85
Overconfidence	3.8	0.91
Risk Aversion	4.0	0.78
Market Rumors	4.1	0.88
Media Influence	4.3	0.82

 

The results show that media influence (M = 4.3) and herd behavior (M = 4.2) are the most significant psychological factors influencing investor sentiment. A correlation analysis between investor sentiment scores and perceived market volatility (measured using a self-reported 5-point scale) showed a moderately strong positive correlation (r = 0.61, p < 0.01), indicating that higher sentiment-driven behavior is associated with higher perceived market volatility.

Additionally, 58% of respondents admitted that they were likely to follow market trends without independent analysis, confirming the prevalence of herd behavior. This suggests that psychological biases play a critical role in shaping market sentiment, often amplifying volatility during uncertain market phases.

To evaluate this relationship between investor sentiment indicators and market performance, respondents were asked to rate their sentiment on a scale of 1 (very pessimistic) to 5 (very optimistic) across three recent market phases: bullish, bearish, and volatile. The sentiment scores were then compared with NIFTY 50 performance data during the same periods.

Market Phase	Average Sentiment Score	NIFTY 50 Avg. Return (%)
Bullish	4.5	+7.2%
Bearish	2.1	-5.8%
Volatile	3.0	±0.6%

 

NIFTY 50 return was the dependent variable and investor sentiment was the independent variable in a regression study. With an R2 value of 0.53 from the regression model, mood indicators may account for almost 53% of the variance in market performance.

A statistically significant positive correlation between investor emotion and market performance is shown by the regression coefficient (β = 0.68, p < 0.01). This suggests that market performance tends to increase when sentiment gets more upbeat and vice versa. Additionally, in positive markets, sentiment-driven investing strategies seemed to be more responsive, but in bearish markets, more cautious or risk-averse methods predominated.

 

5.  Conclusions

Based on the findings of the study, it can be concluded that psychological factors such as media influence, herd behavior, and risk aversion significantly shape investor sentiment and contribute to stock market volatility in the Indian context. The analysis revealed that sentiment-driven behavior often intensifies during uncertain or fluctuating market conditions, leading to irrational investment decisions and heightened market movements. Empirical evaluation further confirmed a strong positive relationship between investor sentiment indicators and market performance, with sentiment accounting for a substantial proportion of market return variability. These insights underscore the critical role of behavioral aspects in financial decision-making and highlight the importance of incorporating investor sentiment into market analysis and investment strategy formulation.

 

6.  Recommendations

Based on the conclusions drawn, it is recommended that investors should develop greater awareness of psychological biases such as herd behavior, overconfidence, and media-driven reactions to make more informed and rational investment decisions. Financial advisors and market analysts should incorporate behavioral insights into their advisory models to better guide investors during volatile market phases. Regulatory bodies and financial institutions may also consider promoting investor education programs that focus on emotional discipline and risk management. Additionally, integrating sentiment analysis tools with traditional financial metrics can help investors and portfolio managers enhance market prediction accuracy and reduce the impact of sentiment-driven volatility on investment outcomes.

 

CONFLICT OF INTERESTS

None. 

 

ACKNOWLEDGMENTS

None.

 

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