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

  • Author(s): BERNARD DUMAS, ALEXANDER KURSHEV, RAMAN UPPAL
  • Published: Mar 13, 2009
  • Pages: 579-629
  • DOI: 10.1111/j.1540-6261.2009.01444.x

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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