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

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Author Info

  • Bernard Dumas

    (INSEAD, University of Pennsylvania (The Wharton School), CEPR and NBER)

  • Alexander Kurshev

    (London Business School)

  • Raman Uppal

    (London Business School and CEPR)

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.”

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Bibliographic Info

Paper provided by Swiss Finance Institute in its series Swiss Finance Institute Research Paper Series with number 06-19.

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Length: 47 pages
Date of creation: Oct 2005
Date of revision:
Handle: RePEc:chf:rpseri:rp0619

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Web page: http://www.SwissFinanceInstitute.ch
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Related research

Keywords: Bayesian behavior; irrational behavior; financial-market equilibrium; excess volatility; risk premia; noise traders; survival.;

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References

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Cited by:
  1. Wei Xiong & Hongjun Yan & Review Financial, 2007. "Heterogeneous Expectations and Bond Markets," Yale School of Management Working Papers amz2614, Yale School of Management, revised 01 Jun 2009.
  2. Bertrand BLANCHETON (GREThA UMR CNRS 5113) & Yves JEGOUREL (LAREFI), 2009. "Sovereign wealth funds: toward a new state capitalism? (In French)," Cahiers du GREThA 2009-04, Groupe de Recherche en Economie Théorique et Appliquée.
  3. Crystal Lin & Hamid Rahman & Kenneth Yung, 2009. "Investor Sentiment and REIT Returns," The Journal of Real Estate Finance and Economics, Springer, vol. 39(4), pages 450-471, November.
  4. A. A. Brown, 2009. "Heterogeneous Beliefs with Partial Observations," Papers 0907.4950, arXiv.org.

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