Introduction

At the beginning of 2020, the whole world practically came to a stop due to the birth of a virus called
coronavirus which eventually became a pandemic. With such a disproportionately high mortality toll
among the elderly and the more vulnerable members of society, this virus had devastating social,
political, and economic effects on the entire planet. As a consequence of the virus’s impact on
supply chains and production in China, the United States of America, Europe, and Japan – not to
mention the world’s most important economies – it triggered unforeseen interruptions in the
movement of goods and services, commodity prices, and financial conditions, resulting in economic
disasters across many countries. This essay will talk about the theories of Efficient Market
Hypothesis (EMH) and behavioural finance as well as how these factors are related to investor
sentiment.

The relevant theories of efficient market hypothesis (EMH) and behavioural finance

EMH is a theory where the presence of new information in the market is then instantly reflected in
share prices (Downey, 2021). Therefore, a technical analysis which is the review of previous share
prices in an attempt to forecast future prices as well as a fundamental analysis which is the study of
financial information will not be able to assist an investor in generating profits greater than those of
a randomly chosen stock portfolio (Malkiel, 2003). Based on the theory of EMH, on exchanges,
shares are always traded at their fair value, making it impossible for investors to acquire
undervalued securities or sell them at overpriced prices. As a result, outperforming the market as a
whole through skilled stock selection or market timing might be unattainable, and the only way for
an investor to earn higher returns is to choose riskier stocks (Downey, 2021).

According to (Fama, 1965), there are three variants of the EMH hypothesis: weak, semi-strong, and
strong form. The weak form of the EMH assumes that security prices represent all market
information that is available to the public, but it might not depict recently available information. It
also suggests that historical price, volume, and return data are unaffected by future pricing (CFI,
2023). Another implicit assumption of the weak form of the EMH would be that technical trading
systems cannot produce continuous excess returns because historical price performance cannot
predict future price action based on new information. The EMH theory’s semi-strong form is neutral
towards either technical or fundamental analysis. The semi-strong variant of the EMH includes
assumptions of the weak form while giving the idea that prices react swiftly to any additional
information that becomes publicly available; thus, eliminating the potential for fundamental analysis
to accurately predict future price movements (CFI, 2023). As an example, in the United States, when
the monthly Payroll report is published every month, the prices would immediately change as the
new information is entering the market. Based on the strong form of the EMH, market prices
accurately reflect all obtainable information. Everything that has ever been or is currently available
to the public is included here, as well as any information that has been made available to the public
with the appropriate level of security clearance. Therefore, the strong form of the EMH states that
investors cannot get a predictive edge, such as outperforming the market average returns, using any
information source other than the market itself (CFI, 2023).

Behavioural finance is a subject of behavioural economics that speculates that investors and
financial professionals’ decisions are affected by their own psychological influences and biases
(Hayes, 2022). Discrepancies in the share market, such as sudden price increases or decreases, can
also be explained by effects and biases in the market. The field of behavioural finance is open to
multiple levels of exploration. The goal of the behavioural finance classification is to shed light on the
factors that motivate people to make specific financial decisions and how such decisions can have an
impact on markets. When it comes to the field of behavioural finance, it is thought that the
participants in the market are not entirely logical and in control of their emotions, but rather that
they are psychologically influential with a rather normal and self-controlling tendency. The investor’s
state of mind and body often have a role in the quality of their financial decisions. There is a strong
correlation between an investor’s mental state and his or her physical health. This affects their
ability to make sound choices and apply logic to any real-world challenge, including financial matters.
The assumption of the efficient market hypothesis is that investors have instant access to all relevant
data and news. Similarly, behavioural finance operates under the same assumption. However, the
field of behavioural finance asserts that people’s subjective interpretations of information and news
have a significant role in the investing decisions they ultimately make. Individual differences in
background, upbringing, culture, and emotional state all contribute to how individuals interpret the
available information (Yildirim, 2017).

Effect of investor sentiment on stock market with examples of the COVID-19 pandemic

The term “investor sentiment” is used to describe the general feeling of investors about certain
securities or financial market. A market’s sentiment can be gauged by looking at how the prices of
different assets in that market have been changing and by interpreting the general sentiment of the
investing public (Smith, 2019). In general, an upward price movement indicates positive market
sentiment, whereas a downward price movement indicates market sentiment that is not favourable.
Investor sentiment may not always reflect reality. Investors’ feelings about a security can generate
sudden price swings, and day traders and technical analysts depend on investor sentiment to inform
the technical indicators they employ to gauge and profit from these swings. Investors who like to go
against the grain of popular opinion, or “contrarians,” also place a premium on reading the market’s
attitude. A view about the predicted cash flow and related risks that is not supported by the
evidence that are now available is an example of investor sentiment. Irrational investors who are
also known as “noise traders” or “uninformed traders” can have an impact on stock prices through
the “correlated” demand shocks they create. Rapid mispricing occurs as a direct consequence of
these unexpected increases in demand. Stock prices are continuously off because wagering against
investor sentiment is difficult and expensive. According to behavioural finance theory, the mood of
investors is a major factor in making investment decisions, setting asset prices, and managing risk
(Gao et al., 2022). Stock market fluctuations, such as volatility or even short-term spikes, have been
linked to investor sentiment in particular, according to a number of theoretical models. Indeed,
investor sentiment assessment provides the groundwork for further study of applications. Indicators
of investor sentiment have traditionally been a focal point of research because of the difficulty in
directly measuring investor emotions. Previously, the closed-end fund puzzle had not been explained
until Lee, Shleifer and Thaler (1991) used the discount rate of closed-end funds as a proxy for
investor sentiment. Thereafter, the formal suggestion of measuring investor sentiment was made.

Moving on, Baker and Wurgler (2006) attribute the mispricing to the enduring impact of investor
sentiment which is in turn caused by misinformed demand shocks and constraints on arbitrage. First,
demand shocks caused by insufficient information tend to last for a while because the false ideas of
some investors are often reinforced by the actions of others who “jump on the bandwagon”.
Second, investors with short investment horizons and limited knowledge of how long irrational
market effects can last are hampered by arbitrage restrictions from mitigating the influence of
investor sentiment on the market. Overconfidence (pessimism) leads to high (low) current returns,
and the mean-reverting feature eventually corrects overpricing (under-pricing) with low (high)
subsequent returns. The theoretical analysis has been mostly backed up by existing empirical
research. Small-cap investor sentiment is “a reliable opposing indicator of future S&P 500 results,” as
confirmed by Fisher and Statman (2000). Based on their research, Brown and Cliff (2005) discovered
that investor attitude is inversely related to DJIA returns within the next one to three years.

The World Health Organization declared the coronavirus disease (COVID-19) a global pandemic in
March 2020, prompting several governments to impose stringent quarantine policies that had far-
reaching ramifications for global economic activity (Smales, 2021). Because of the lockdowns, the
entire economy, particularly the financial markets, entered a deep crisis. Following the global
pandemic, governments implemented several safeguards, such as strict quarantine rules, which
created new issues that necessitated new forms of technology and innovation to address (Kou et al.,
2021). According to Nedumparambi and Chundakkadan (2021), rapid drops in stock markets are
caused by both economic lockdowns and differences in investor sentiment during the COVID-19
pandemic. The prolonged duration of the COVID-19 pandemic has significantly contributed to
increased market volatility (Mazur, Dang and Vega, 2021). Investor interest, according to Smales
(2021), plays a critical role in the effect of the COVID-19 pandemic on stock markets, and investor
interest is growing as they try to make sense of the ongoing uncertainties surrounding the global
pandemic. Since Da, Engelberg, and Gao (2011) first introduced the concept, the Google Search
Volume Index (GSVI) has been widely used to measure investor interest or sentiment. Smales (2021)
also stated that the GSVI is a direct and immediate assessment of the retrieval of available data.
Given the widespread concern about COVID-19, it's not surprising that a fear index based on internet
search queries about the virus has been created (Cevik et al., 2022). As a result, the majority of
empirical studies on the impact of negative investor sentiment on stock markets have focused on
the GSVI in relation to COVID-19. However, Chundakkadan and Nedumparambil (2021) noted that
the narrow focus on pessimistic investor sentiment in these studies is a weakness. They noted that
the global pandemic has benefited the pharmaceutical and biotechnology industries, but that it is
difficult to tell whether people's attitudes are positive or negative in the midst of the epidemic. For
example, Nofsinger (2005) investigated the relationship between investors' social mood and trading
activity and concluded that investor optimism predicts increased business and investment activity.To
determine how media coverage of COVID-19 affects investor sentiment, Haroon and Rizvi (2020)
studied the correlation between market volatility and stock market uncertainty. Research shows that
news about COVID-19 raises investor anxiety and increases stock price volatility. Eight stock market
indexes were studied by Ambros et al. (2021) to determine their reaction to news about COVID-19.
Their data shows that the COVID-19 announcement increased volatility in European stock markets
but had little effect on stock returns. Using COVID-19 related Google search phrases, Iyke and Ho
(2021) assessed investor interest and analysed its correlation with stock market indexes across 14
African nations. Stock returns in Botswana, Nigeria, and Zambia were found to be significantly
influenced by the level of investor interest in the stock market. Meanwhile, in both Ghana and
Tanzania, increased levels of investor interest correlate with higher stock market returns.

Conclusion

According to research by Baker and Wurgler (2007), during times of economic uncertainty, investor
sentiment can have a greater influence on the stock market than fundamentals. The global financial
markets have been under extreme pressure since the COVID-19 pandemic broke out. The effects of
shifts in investor sentiment on the stock market have been the subject of recent research. Smales
(2021) added that investors gave more importance to the coronavirus during the COVID-19
pandemic, and this is significant because investor attention is strongly connected with stock market
volatility. Similarly, Sun, Bao and Lu (2020) discovered that the effect of coronavirus-related news
(CRNs) and economic-related news (ERAs) related to the COVID-19 epidemic on investor sentiment
varied from country to country.