TY  - JOUR
AU  - Dumas,Bernard
AU  - Kurshev,Alexander
AU  - Uppal,Raman
TI  - Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 13401
PY  - 2007
Y2  - September 2007
UR  - http://www.nber.org/papers/w13401
L1  - http://www.nber.org/papers/w13401.pdf
N1  - Author contact info:
Bernard Dumas
Université de Lausanne
Institut de Banque et Finance
Bâtiment Extranef
1015 Lausanne
Switzerland
Tel: +41 (21) 692 36 50
E-Mail: bernard.dumas@unil.ch

Alexander Kurshev
London Business School
E-Mail: akurshev.PHD2003@london.edu

Raman Uppal
London Business School
Regents Park
London NW1 4SA
UK
Tel: 44-20-7706-6883
E-Mail: ruppal@london.edu
AB  - 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 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 overconfident 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 overconfident traders introduce an additional source of risk, rational investors are deterred by their presence and 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 their expectation of future sentiment behavior and a prediction concerning the speed of convergence of prices. 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."
ER  -