Working Paper: CEPR ID: DP5367
Authors: Bernard J. Dumas; Alexander Kurshev; Raman Uppal
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 analyse 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 behaviour 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: Behavioral Equilibrium Theory; Non-Bayesian Behaviour; Portfolio Choice
JEL Codes: G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Irrational traders (G41) | Rational investors reduce equity investments (G11) |
| Irrational traders (G41) | Excessive volatility in stock prices (G17) |
| Excessive volatility in stock prices (G17) | Rational investors adjust portfolio strategies (G11) |
| Rational investors' expectations regarding future behavior of irrational traders (D84) | Rational investors' optimal portfolio strategy (G11) |
| Long-maturity bonds (G12) | Hedging sentiment risk (G41) |