Working Paper: CEPR ID: DP6455
Authors: Bernard J. Dumas; Alexander Kurshev; Raman Uppal
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 behaviour 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 behaviour; Excess volatility; Financial market equilibrium; Risk premia
JEL Codes: C11; D58; D84; D91
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| overconfident traders (G41) | excessive volatility in stock prices (G17) |
| overconfident traders (G41) | risk perception of rational investors (G41) |
| risk perception of rational investors (G41) | decrease in equity investments (G12) |
| sentiment fluctuations (E32) | investor behavior (G41) |
| sentiment fluctuations (E32) | market outcomes (P42) |
| excessive volatility in stock prices (G17) | additional risk for rational investors (G40) |
| investor behavior (G41) | optimal portfolio strategy for rational investors (G11) |
| long maturity bonds (G12) | hedge against sentiment risk (G41) |