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

Dumas, B, Kurshev, A and Uppal, R (2007) Equilibrium Portfolio Strategies in the Presence of Sentiment Risk and Excess Volatility. Working Paper. London Business School IFA Working Paper.

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 generalequilibrium "differenceofopinion" model of sentiment in which there are two classes of agents, one of which is overconfident about a public signal, while still being intertemporal optimizers. The overconfident investors overreact to the signal and change their expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. They thereby introduce an additional risk factor, cause stock prices to be excessively volatile, and induce rational invstors to be conservative in their bond and equity investment. Moreover, the rational investor's portfolio stragegy is based not just on a current price divergence but also on their prediction about future sentiment behavior and the speed of convergence of prices.