Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility

51 Pages Posted: 14 Sep 2007 Last revised: 13 Feb 2022

See all articles by Bernard Dumas

Bernard Dumas

INSEAD; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Alexander Kurshev

London Business School

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 6 versions of this paper

Date Written: September 2007

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."

Suggested Citation

Dumas, Bernard and Kurshev, Alexander and Uppal, Raman, Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility (September 2007). NBER Working Paper No. w13401, Available at SSRN: https://ssrn.com/abstract=1014348

Bernard Dumas (Contact Author)

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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Alexander Kurshev

London Business School ( email )

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Raman Uppal

EDHEC Business School ( email )

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Centre for Economic Policy Research (CEPR)

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United Kingdom

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