Investor sentiment and bid-ask spreads: The role of retail investors

Document Type

Article

Publication Title

Journal of Behavioral and Experimental Finance

Publication Date

12-1-2026

Abstract

We examine how investor sentiment influences stock market liquidity by decomposing the bid-ask spread into the realized-spread (a proxy for market-maker inventory costs) and the price-impact (a proxy for adverse selection costs and informed trading). Using high-frequency data, we find that higher investor sentiment improves liquidity overall, with reductions in adverse-selection costs more than offsetting increases in inventory costs. The liquidity improvement is asymmetric, with adverse selection costs declining more for buyer-initiated trades than for seller-initiated trades, consistent with increased retail buying during high sentiment periods. Our evidence suggests that market-makers respond to this retail-driven demand by lowering institutional sell-side commissions. Our findings are robust to alternative sentiment measures, retail-trade classifications and various sample periods. Overall, we identify mechanisms through which investor sentiment affects liquidity, advancing the behavioral and microstructure literature on retail trading and market-making dynamics.

Volume

52

DOI

10.1016/j.jbef.2026.101258

ISSN

22146350

E-ISSN

22146369

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