Working Paper: NBER ID: w13401
Authors: Bernard 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 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: Sentiment Risk; Excess Volatility; Portfolio Strategies
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 investors (G41) | excessive volatility (E32) |
| overconfident beliefs (D83) | excessive volatility (E32) |
| excessive volatility (E32) | rational investors reduce equity investments (G11) |
| overconfident traders (G41) | risk environment for rational investors (G11) |
| overconfident traders (G41) | rational investors' optimal portfolio strategies (G11) |
| long maturity bonds (G12) | hedging sentiment risk (G41) |