Quantifying irrational sentiment

Todd Feldman

Abstract

ABSTRACT

The measure exploits two biases, loss aversion and recency, to create two indicators: a rational sentiment indicator and an irrational one. The rational indicator mutes the biases, while the irrational indicator turns the biases on. The irrational-rational index (IRI) equals the spread between the two indicators. A large gap between the two indicators signifies greater irrational sentiment in the marketplace. I test whether these large gaps in the IRI lead to US stock price reversals to the mean. Results indicate that the IRI is successful in detecting irrational fear, but that it is not successful in detecting irrational optimism. Even so, the IRI was able to detect irrational optimism and fear before and after the two largest crises since 1980: those in 1987 and in 2008.