What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations?

Bernard Dumas (), Alexander Kurshev and Raman Uppal

No 11803, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Our objective is to understand the trading strategy that would allow an investor to take advantage of "excessive" stock price volatility and "sentiment" fluctuations. We construct a general equilibrium model of sentiment. In it, there are two classes of agents and stock prices are excessively volatile because one class is overconfident about a public signal. This class of irrational agents changes its expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. We find that because irrational traders introduce an additional source of risk, rational investors reduce the proportion of wealth invested into equity except when they are extremely optimistic about future growth. Moreover, their optimal portfolio strategy is based not just on a current price divergence but also on a prediction concerning the speed of convergence. Thus, the portfolio strategy includes a protection in case there is a deviation from that prediction. We find that long maturity bonds are an essential accompaniment of equity investment, as they serve to hedge this "sentiment risk." The answer to the question posed in the title is: "There is little that rational investors can do optimally to exploit, and hence, eliminate excessive volatility, except in the very long run."

JEL-codes: G1 (search for similar items in EconPapers)
Date: 2005-11
New Economics Papers: this item is included in nep-fin and nep-fmk
Note: AP
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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Working Paper: What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations? (2006)
Working Paper: What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations? (2005)
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