Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility

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

No 07-37, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: Our objective is to identify 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 overconfident 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 overconfident traders introduce an additional source of risk, rational investors are deterred by their presence and 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 their expectation of future sentiment behavior and a prediction concerning the speed of convergence of prices. 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.”

Keywords: Bayesian behavior; financial-market equilibrium; excess volatility; risk premia. (search for similar items in EconPapers)
JEL-codes: C11 D58 D84 D91 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2007-07
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Citations: View citations in EconPapers (8)

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Related works:
Journal Article: Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility (2009)
Working Paper: Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility (2007)
Working Paper: Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp0737

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