Analysis Of The Relationship Between Idiosyncratic Risk And Expected Return In China Stock Market

Under the traditional Capital Asset Pricing Model(CAPM)theory,the capital market is based on the assumption of no information cost and frictionless,while investors are completely risk averse and rationality objective.According to the above theory,the systemic risk through stock portfolio cannot be eliminated due to market factors,while the non-systemic risk can be completely dispersed by diversified portfolio and will not have a correlated impact on the whole market.In other words,unsystematic risk can be eliminated and there is no need for risk compensation during asset pricing process.However,huge studies have shown that China stock market has serious problems such as market friction,information asymmetry,large proportion of individual investors,and urgent need to improve the structure of financial market.The investment portfolio held by investors still needs to exposure additional idiosyncratic risk caused by some special factors that have no systematic connection with the whole securities market,and this risk must be borne by investors themselves.Therefore,it is difficult for investors to construct a portfolio that can completely disperse unsystematic risk,and there are also differences in expected returns.Researchers early believed that investors would correspondingly require higher compensation returns(expected return)when they assumed idiosyncratic risk,as a result,there existed a positive correlation between idiosyncratic risk and expected return.However,more research results have showed that there is a negative correlation between idiosyncratic risk and expected return.In consequence,this phenomenon is known as the ‘Trait Volatility Puzzle’.Most scholars have explained this anomaly from the perspectives of short-selling restriction.In addition,there are still other anomalies in the financial market that cannot be explained by traditional models.In order to explain these financial anomalies,scholars are encouraged to focus on the psychological characteristics of investors.In order to explain these financial anomalies,scholars have focused on the perspective of investor behavior to explore deeper factors affecting risk and return,and thus,they have conducted research on behavioral finance.In the field of behavioral finance,investors are not completely rational.Such heterogeneous individual cognitive biases of investors converge to the overall level of the market,that is,investor sentiment in the capital market.Emotions affect investors’ investment decisions by influencing their internal and external information processing.This paper attempts to analyze the correlation between idiosyncratic risk and expected return in China stock market from the perspective of investor sentiment.From the perspective of behavioral finance,this paper attempts to establish investor sentiment index when analyzing the relationship.From the perspective of behavioral finance,this paper attempts to analyze the correlation between idiosyncrasies and expected returns in China stock market from the perspective of investor sentiment by establishing investor sentiment index.Referring to previous studies,this paper uses idiosyncratic volatility to represent idiosyncratic risk and expected return rate to represent expected return.For the first time,this paper uses all transaction data of all China A-shares from January 2006 to December 2021,selects multiple comprehensive indicators to construct investor sentiment index,The commonly used Fama-French model is used to calculate the idiosyncratic volatility,and expected return rate in China stock market is calculated by univariate group and Fama-Mac Beth regression method.Meanwhile,univariate grouping analysis,bivariate grouping analysis and Fama-Mac Beth regression method are used to verify the ‘idiosyncratic volatility puzzle’ in China stock market.The research of this paper shows that there is an anomaly of ‘idiosyncratic volatility puzzle’ in China stock market.Investor sentiment changes will affect the anomaly of ‘idiosyncratic volatility puzzle’ in China stock market,and leads to stock mispricing.When investor sentiment is higher(optimistic),the negative correlation between stock idiosyncratic volatility and expected return rate is more significant.Considering that China stock market was affected by the 2008 financial crisis,this paper takes 2009 as the time node to test the robustness of the samples,which still supports the above conclusions.In conclusion,this paper verifies the anomaly of the existence of ‘idiosyncratic volatility puzzle’ in China stock market,which can be explained by investor sentiment fluctuations.This makes it difficult for traditional theoretical models to make a reasonable interpretation of some financial phenomena.As a result,investors should consider more aspects than simply relying on capital asset pricing model when making investment portfolio.From the empirical results,there is not necessarily a positive correlation between high risk and high return.Therefore,investors should make a balance when making the decision to buy and sell stocks.Government financial supervision departments and financial institutions should vigorously carry out investor education activities to help investors improve financial literacy and financial investment ability,so as to avoid irrational decisions caused by investor emotional disturbance.Managers of listed companies can also monitor and predict investor sentiment to prevent irrational stock price fluctuations caused by large fluctuations of market investor sentiment,which may have adverse effects on the company.Market regulators can effectively guide and stabilize the stock market by detecting investor sentiment.