Sentiment, Mispricing and Excess Volatility in Presence of Institutional Investors

e study the equilibrium implications on asset prices of institutions’ trading with sentimentdriven retail investors. In the model, both the benchmarking concerns of institutions and the (irrational) optimism of retail investors boost the aggregate demand for a stock. We show that the ensuing demand pressure has a depressing effect on the stock market price of risk but an ambiguous effect on volatility. The overall effect on volatility results from the interplay of a benchmarking and a relative-wealth channels on the transmission of fundamental news to prices. This interplay can induce a negative relation between the degree of irrationality of the sentimentdriven investors and the stock return’s excess volatility, in stark contrast with a well-known prediction of models with no institutional investors. It further creates novel countercyclical patternsin stock volatility that cannot be explained in the absence of sentiment. Our results have a number of implications for the interpretation of the empirically documented dynamics of mispricing and excess volatility of financial assets.