What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations? / Bernard Dumas, Alexander Kurshev, Raman Uppal.

Format:

Book

Author/Creator:

Dumas, Bernard.

Contributor:

National Bureau of Economic Research.

Kurshev, Alexander.

Uppal, Raman.

Series:

Working Paper Series (National Bureau of Economic Research) no. w11803.

NBER working paper series no. w11803

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2005.

Summary:

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. This class of irrational agents changes its expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. 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 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." 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."

Notes:

Print version record

November 2005.