What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations?
INSEAD; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)
London Business School
EDHEC Business School; Centre for Economic Policy Research (CEPR)
Swiss Finance Institute Research Paper No. 06-19
AFA 2007 Chicago Meetings Paper
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 analyze 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 behavior 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."
Number of Pages in PDF File: 50
Keywords: Dynamic portfolio choice, excess volatility, general equilibrium
JEL Classification: G1working papers series
Date posted: March 10, 2006
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