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

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  • BERNARD DUMAS
  • ALEXANDER KURSHEV
  • RAMAN UPPAL

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 “difference‐of‐opinion” model of sentiment in which there are two classes of agents, one of which is overconfident about a public signal, while still optimizing intertemporally. Overconfident investors overreact to the signal and introduce an additional risk factor causing stock prices to be excessively volatile. Consequently, rational investors choose a conservative portfolio; moreover, this portfolio depends not just on the current price divergence but also on their prediction about future sentiment and the speed of price convergence.

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  • Bernard Dumas & Alexander Kurshev & Raman Uppal, 2009. "Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility," Journal of Finance, American Finance Association, vol. 64(2), pages 579-629, April.
  • Handle: RePEc:bla:jfinan:v:64:y:2009:i:2:p:579-629
    DOI: 10.1111/j.1540-6261.2009.01444.x
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    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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