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 INSEAD boulevard de Constance 77305 Fontainebleau Cedex FRANCE Tel: +33 1 60 72 43 73 Fax: +33 1 60 72 40 50 E-Mail: bernard.dumas@insead.edu Alexander Kurshev London Business School E-Mail: akurshev.PHD2003@london.edu Raman Uppal EDHEC Business School 10 Fleet Place, Ludgate London EC4M 7RB United Kingdom Tel: +44 20 7871 6740 E-Mail: ruppal@mac.com 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 -