What Can Rational Investors Do About Excessive Volatility?

Abstract

We determine and analyze the trading strategy that would allow an investor to take advantage of the excessive stock price volatility that has been documented in the empirical literature on asset pricing. We construct a general equilibrium model where stock prices are excessively volatile because there are two classes of agents and one class places is overconfident about a public signal. As a result, these agents change their expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. We analyze the trading strategy of the rational investors who are not overconfident about the signal. While rational risk-arbitrageurs benefit from trading on their belief that the market is being foolish, when doing so they must hedge future fluctuations in the market's foolishness. We find that fixed-income instruments can be used for the purpose of hedging. Thus, our analysis illustrates that risk arbitrage cannot be based on just a current price divergence; it must include also a protection against trading risk. We also show that the presence of a few rational traders is not sufficient to eliminate the excessive volatility effect of overconfident investors generated by the presence of overconfident investors. Furthermore, overconfident investors of this kind tend to survive for a long time before being driven out of the market by rational investors.