Systematic risk, government policy intervention, and dynamic contrarian investments

When systematic risk is high, or the market crashes, most risk-averse investors choose to exit the market; however, there are some contrarian investors who opt to make investments. We model such contrarian behaviors by incorporating investors’ expectations of government policies into the conventional risk-return trade-off framework. We show that when policy risk is expected to be low and the market has a high probability to recover, subsequent to the government’s intervention, the optimal decision for investors is to make investments. On the other hand, when policy risk is high and the market has a high probability to deteriorate, the optimal investment decision is to exit. Our simulation results are consistent with the model predictions.