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

Bernard Dumas (), Alexander Kurshev and Raman Uppal
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Alexander Kurshev: London Business School

No 06-19, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

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. As a result, this class of irrational agents changes its expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. We determine and analyze the trading strategy of the rational investors who are not overconfident about the signal. 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 model of irrational behavior and 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.” Even though rational investors find it beneficial to trade on their belief that the market is excessively volatile, 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.”

Keywords: Bayesian behavior; irrational behavior; financial-market equilibrium; excess volatility; risk premia; noise traders; survival. (search for similar items in EconPapers)
JEL-codes: C11 D58 D84 D91 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2006-10
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Citations: View citations in EconPapers (7)

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Related works:
Working Paper: What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations? (2005)
Working Paper: What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations? (2005)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp0619

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