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





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    • Bernard Dumas is from University of Lausanne, Swiss Finance Institute, NBER, and CEPR. Alexander Kurshev is from the London Business School. Raman Uppal is from London Business School and CEPR. Dumas acknowledges with thanks the financial support of the Swiss National Center for Competence in Research “FinRisk.” The authors thank an anonymous referee and the editor, Campbell Harvey, for comments. The authors are grateful to Wei Xiong, Tony Berrada, Julien Hugonnier, Erwan Morellec, and Emilio Osambela for useful discussions. They are also grateful for suggestions from Andrew Abel, Nick Barberis, Suleyman Basak, Tomas Björk, Andrea Buraschi, Joao Cocco, John Cochrane, George Constantinides, John Cotter, Alexander David, Xavier Gabaix, Mike Gallmeyer, Lorenzo Garlappi, Francisco Gomes, Joao Gomes, Tim Johnson, Leonid Kogan, Kostas Koufopoulos, Karen Lewis, Deborah Lucas, Pascal Maenhout, Massimo Massa, Stavros Panageas, Anna Pavlova, Ludovic Phalippou, Valery Polkovnichencko, Bryan Routledge, Jose Scheinkman, Andrew Scott, Hersh Shefrin, Matt Spiegel, Alex Stomper, Allan Timmermann, Skander van den Heuvel, Luis Viceira, Jiang Wang, Pierre-Olivier Weill, Hongjun Yan, Amir Yaron, Moto Yogo, Joseph Zechner, Stanley Zin, and participants at presentations given at Bank of England, Columbia University, Durham University, HEC Paris, Imperial College, INSEAD, Judge Institute at Cambridge University, London Business School, London School of Economics, Massachusetts Institute of Technology, New York University, Oxford University, Princeton University, Stanford University, University of California at Berkeley, University College Dublin, University of Frankfurt, University of Piraeus, University of Texas at Austin, University of Toulouse, University of Vienna, University of Zurich, Wharton School, Yale University, American Finance Association Meeting, Citigroup Smith Barney Quantitative Conference, Duke/UNC Asset Pricing Conference, European Finance Association Meeting, European Summer Symposium in Financial Markets at Gerzensee, European Central Bank, Isaac Newton Institute at Cambridge University, NBER workshop on Capital Markets and the Economy, NBER Summer Institute, NBER Asset Pricing Meeting, the Swiss Finance Institute, and the Swiss National Bank.


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.