“Humans are disturbed not by things, but by the views they take of them.”
– Epictetus (ish)
Disclaimer: this article may have been conceived after a particularly great avgolemono I had recently. The Greeks really were crushing it way back when…
In the modern era of investing—where trillions of dollars move at the speed of a tweet—the concept of investor sentiment has taken on heightened significance. Investor sentiment is a term used frequently by analysts, fund managers, and financial journalists, but what does it really mean? More importantly, should it matter to long-term investors?
At its core, investor sentiment refers to the overall mood or tone of the market, as reflected in the behavior and decision-making patterns of its participants. It is not necessarily grounded in fundamentals (in fact, sentiment and fundamental analysis can be in opposition from time to time), but rather in perception. Markets, after all, are not driven solely by balance sheets and earnings reports, but by the collective psychology of those who trade within them.
The Case Against Sentiment: Noise Over Signal?
Some argue that investor sentiment is a distraction—little more than the speculative froth on top of the latte that is a rational capital market. In this view, chasing trends based on feelings/instincts, price action only, or crowd psychology can lead to “chasing returns,” potential overreaction, or a kind of emotional contagion (fear of missing out, to name one). Critics of sentiment-based investing often point to momentum strategies as temporary fads—strategies that work until they don’t, driven more by the self-fulfilling nature of short-term demand than by lasting value.
To these skeptics, the reliance on sentiment metrics (such as the Fear & Greed Index, put-call ratios, or investor surveys) amounts to reading tea leaves. These critics argue that sentiment is just a reflection of recent performance, not a predictive signal. When the S&P 500 is rising, sentiment improves. When markets fall, sentiment turns negative. Correlation? Yes. Causation? Uh… harder to say.
Lastly, those momentum haters might cite the various times when a market “bubble” has popped and those who were all-in or “risk on” paid a heavy price. Given the relative rarity of market bubbles, I am not sure this point holds up well, but it is certainly one to consider as volatility (and the potential for market bubbles) increases.
The Case For Sentiment: Behavioral Truths in Motion
To ignore investor sentiment entirely is to overlook the profound role that human behavior plays in asset pricing. After all, isn’t a market simply the collection of investors—most of whom are still human?
Sentiment may not be perfectly quantifiable, but it’s real—and behavioral finance has spent decades making the case for its significance. One home for this school of thought draws on Kahneman and Tversky’s (1979) prospect theory, which demonstrates that loss aversion, confirmation bias, and herding behavior shape market cycles just as much as earnings and interest rates. Investor sentiment, then, is not a glitch or bug in the system—it is the system.
Momentum investing, far from being a modern “fad,” has been observed for centuries. Numerous academic studies have found that stocks which outperform over the short term tend to continue outperforming—at least for a time. From this angle, investor sentiment becomes an important complement to traditional analysis. It is not a rejection of fundamentals but a recognition that markets are (at least in part) social constructs, not just mathematical ones.
Momentum skeptics argue that fundamental analysis removes the unknowable sentiment element and instead relies on historical data—and concepts of finance that have proven sound if not valuable to investors for decades (if not centuries). But must that skeptic also ask themselves: can all market movement be explained by analytics and metrics?
To quote another Greek philosopher, Heraclitus: “No man ever steps in the same river twice, for it is not the same river and he is not the same man.” I really love this quote and have used it over the years to describe all sorts of situations. It certainly applies to investing as well. Markets, like rivers, are in constant flux—and so are the people who participate in them. The direction, momentum, sentiment of those people should not go unconsidered.
Belief Reinforcement in the Age of Information
Regardless of how you think about markets and where you land on the investor sentiment spectrum, in a world flooded with data, opinions, and infinite content, we may find ourselves drawn not to what is true, but to what is comfortable. This cognitive trap—one might call it confirmation bias—can be especially dangerous for investors.
In fact, it is something I think about all the time: are we seeing this with an open, informed mind, without bias? With personalized newsfeeds, algorithm-driven recommendations, and niche online communities, investors are increasingly exposed only to views that mirror (or at least resemble) their own. A bullish investor will naturally seek out optimistic voices; a bearish one will be drawn to warnings of recession.
Over time, these reinforced perspectives can create ideological bubbles, making it difficult to interpret sentiment (or even sometimes more fundamental data) objectively. This is especially problematic when we consider that investor sentiment is itself driven by perception. If perception is filtered through biased sources, then sentiment becomes not just reactive, but dangerously self-reinforcing.
Wait, is this what The Matrix was about?!
Sentiment, Volatility, and Today’s Market
Based on the above, you might conclude that this confirmation bias and idea distortion has led to increased volatility in markets. It certainly could be concluded that the relevance of sentiment is magnified in today’s market environment—where volatility appears not as an aberration, but a defining characteristic.
By way of a couple of data points:
Over the past 5 years, the S&P 500 has experienced an average of 61 days per year with a ±1% move, compared to 36 such days per year over the prior 20-year period (source: Bloomberg).
The VIX, often referred to as the market’s “fear gauge,” has averaged higher levels in the last decade than in the prior two.
Research shows that greater access to technology, social media, and algorithmic trading may have accelerated the speed at which sentiment shifts, leading to more dramatic swings in asset prices.
This heightened volatility is not merely an emotional inconvenience—it has real implications for risk tolerances, risk management, investment time horizons, and even, therefore, asset allocations. Shouldn’t we, as rational investors, acknowledge that more frequent and severe price swings impact how we invest?
Perhaps sentiment isn’t a distraction after all. Perhaps it is a lens (not the lens, but a lens) through which we must interpret a market environment that no longer adheres to the stable, predictable patterns of the past.
Conclusion… uh, “conclusion”
So, what is your point, Matt (you might be saying)? Well, I think very few answers, strategies, concepts, etc. are strictly this or that—right or wrong. There’s wisdom in distancing ourselves from the emotional swings of the market. Yet there’s equal wisdom in recognizing that markets are moved by sentiment, even if we ourselves aspire to remain calm.
Investors are not bots—well, most investors. They are people: reacting to headlines and reports, responding to uncertainty, interpreting new information through the filters of past experiences and future fears or expectations. The best investors don’t ignore sentiment. They understand it, measure it, and—when appropriate—capitalize on it.
To return to Epictetus (the most epic of all the Tetuses):
“It’s not what happens to you, but how you react to it that matters.”
In investing, as in life, the greatest advantage may come not from knowing what’s coming but from understanding how people will feel about it when it arrives. At East Franklin Capital, we certainly do not know (nor do we even pretend to know) what the future holds, but we can use the past and present to improve our reaction time—all the while remaining disciplined… if nimble.
