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

54 Pages Posted: 11 Dec 2007

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: July 23, 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.

Keywords: Bayesian behavior, financial-market equilibrium, excess volatility, risk premia

JEL Classification: C11, D58, D84, D91

Suggested Citation

Dumas, Bernard and Kurshev, Alexander and Uppal, Raman, Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility (July 23, 2007). Swiss Finance Institute Research Paper No. 07-37. Available at SSRN: https://ssrn.com/abstract=1069582 or http://dx.doi.org/10.2139/ssrn.1069582

Bernard Dumas (Contact Author)

INSEAD ( email )

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HOME PAGE: http://www.insead.fr/~dumas/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alexander Kurshev

London Business School ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

Raman Uppal

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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