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

47 Pages Posted: 22 Jan 2006 Last revised: 3 Apr 2022

See all articles by Bernard Dumas

Bernard Dumas

INSEAD; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Alexander Kurshev

London Business School

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 6 versions of this paper

Date Written: November 2005

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. 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."

Suggested Citation

Dumas, Bernard and Kurshev, Alexander and Uppal, Raman, What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations? (November 2005). NBER Working Paper No. w11803, Available at SSRN: https://ssrn.com/abstract=851712

Bernard Dumas (Contact Author)

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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Alexander Kurshev

London Business School ( email )

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Raman Uppal

EDHEC Business School ( email )

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Centre for Economic Policy Research (CEPR)

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London, EC1V 7RR
United Kingdom

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