| 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 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 behaviour
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.'' |