A Tale of Two Investors : Estimating Optimism and Overconfidence

We estimate investors' sentiment from option and stock prices by anchoring objective beliefs to a neoclassical pricing kernel. Our estimates of sentiment correlate well with other sentiment measures such as the Baker–Wurgler index, the Yale/Shiller crash confidence index and the Duke/CFO survey responses, and yet contain additional information. Our analysis points out three significant issues related to overconfidence. First, the Baker–Wurgler index strongly reflects excessive optimism but not overconfidence. Second, overconfidence drives the pricing kernel puzzle. Third, the dynamics of optimism and overconfidence generate a perceived negative risk-return relationship, while objectively the relationship is positive. Optimism and overconfidence about market returns co-move together, inflating asset prices in good times and exacerbating market crashes in bad times