What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations?

50 Pages Posted: 10 Mar 2006  

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: 2006

Abstract

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."

Keywords: Dynamic portfolio choice, excess volatility, general equilibrium

JEL Classification: G1

Suggested Citation

Dumas, Bernard and Kurshev, Alexander and Uppal , Raman, What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations? (2006). Swiss Finance Institute Research Paper No. 06-19; AFA 2007 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=889562 or http://dx.doi.org/10.2139/ssrn.889562

Bernard Dumas (Contact Author)

INSEAD ( email )

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F-77305 Fontainebleau Cedex
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+33 1 60 72 49 92 (Phone)
+33 1 60 72 40 45 (Fax)

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)

77 Bastwick Street
London, EC1V 3PZ
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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