A Tale of Two Investors: Estimating Optimism and Overconfidence
Swiss Finance Institute at the University of Lugano; Swiss Finance Institute
Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute
Santa Clara University - Leavey School of Business; National Bureau of Economic Research (NBER)
March 15, 2013
Swiss Finance Institute Research Paper No. 12-21
We estimate investors' sentiment from option and stock prices by anchoring objective beliefs to a neoclassical pricing kernel. Our estimates of sentiment correlate well with other sentiment measures such as the Baker-Wurgler index, the Yale/Shiller crash confidence index, the Duke/CFO survey responses, and yet include additional information. Our analysis points out three significant issues related to overconfidence. First, the Baker-Wurgler index strongly reflects excessive optimism but not overconfidence. Second, overconfidence drives the pricing kernel puzzle. Third, the dynamics of optimism and overconfidence generate a perceived negative risk-return relationship, while objectively the relationship is positive. Optimism and overconfidence about S&P 500 growth rates co-move together, inflating asset prices in good times and exacerbating market crashes in bad times.
Number of Pages in PDF File: 92
Keywords: Sentiment, Risk Aversion, Pricing Kernel, Optimism, Overconfidence
JEL Classification: G02, G12working papers series
Date posted: May 18, 2012 ; Last revised: March 18, 2013
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