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

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  • Dumas, Bernard J
  • Kurshev, Alexander
  • Uppal, Raman

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 analyse 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 behaviour 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 C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5367.

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Date of creation: Nov 2005
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Handle: RePEc:cpr:ceprdp:5367

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Keywords: behavioural equilibrium theory; non-Bayesian behaviour; portfolio choice;

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Cited by:
  1. 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.
  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. Wei Xiong & Hongjun Yan, 2006. "Heterogeneous Expectations and Bond Markets," NBER Working Papers 12781, National Bureau of Economic Research, Inc.
  4. A. A. Brown, 2009. "Heterogeneous Beliefs with Partial Observations," Papers 0907.4950, arXiv.org.

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