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Keynes Meets Markowitz: The Trade-Off Between Familiarity and Diversification

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Author Info

  • Phelim Boyle

    ()
    (School of Business and Economics, Wilfrid Laurier University, Waterloo, Ontario N2L 3C5, Canada)

  • Lorenzo Garlappi

    ()
    (Sauder School of Business, University of British Columbia, Vancouver, British Columbia V6T 1Z2, Canada)

  • Raman Uppal

    ()
    (EDHEC Business School, Lille, 59057 Roubaix, France)

  • Tan Wang

    ()
    (China Academy of Financial Research, 200030 Shanghai, People's Republic of China; and Sauder School of Business, University of British Columbia, Vancouver, British Columbia V6T 1Z2, Canada)

Abstract

We develop a model of portfolio choice to nest the views of Keynes, who advocates concentration in a few familiar assets, and Markowitz, who advocates diversification. We use the concepts of ambiguity and ambiguity aversion to formalize the idea of an investor's "familiarity" toward assets. The model shows that for any given level of expected returns, the optimal portfolio depends on two quantities: relative ambiguity across assets and the standard deviation of the expected return estimate for each asset. If both quantities are low, then the optimal portfolio consists of a mix of familiar and unfamiliar assets; moreover, an increase in correlation between assets causes an investor to increase concentration in familiar assets (flight to familiarity). Alternatively, if both quantities are high, then the optimal portfolio contains only the familiar asset(s), as Keynes would have advocated. In the extreme case in which both quantities are very high, no risky asset is held (nonparticipation). This paper was accepted by Brad Barber, Teck Ho, and Terrance Odean, special issue editors.

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File URL: http://dx.doi.org/10.1287/mnsc.1110.1349
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 58 (2012)
Issue (Month): 2 (February)
Pages: 253-272

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Handle: RePEc:inm:ormnsc:v:58:y:2012:i:2:p:253-272

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Keywords: investment; portfolio choice; ambiguity; robust control; underdiversification;

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References

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  1. Bryan R. Routledge, Stanley E. Zin, 2000. "Model Uncertainity And Liquidity," Computing in Economics and Finance 2000 368, Society for Computational Economics.
  2. Larry G. Epstein & JianJun Miao, 2001. "A Two-Person Dynamic Equilibrium under Ambiguity," RCER Working Papers 478, University of Rochester - Center for Economic Research (RCER).
  3. Calvet, Laurent E. & Campbell, John Y. & Sodini, Paolo, 2006. "Down or Out: Assessing The Welfare Costs of Household Investment Mistakes," Working Paper Series 195, Sveriges Riksbank (Central Bank of Sweden).
  4. Kelly, Morgan, 1995. "All their eggs in one basket: Portfolio diversification of US households," Journal of Economic Behavior & Organization, Elsevier, vol. 27(1), pages 87-96, June.
  5. Massa, Massimo & Simonov, Andrei, 2004. "Hedging, Familiarity and Portfolio Choice," CEPR Discussion Papers 4789, C.E.P.R. Discussion Papers.
  6. John Y. Campbell, 2006. "Household Finance," Journal of Finance, American Finance Association, vol. 61(4), pages 1553-1604, 08.
  7. Valery Polkovnichenko, 2005. "Household Portfolio Diversification: A Case for Rank-Dependent Preferences," Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1467-1502.
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Cited by:
  1. Xie, Jun & Yang, Chunpeng, 2013. "Shouldn't all eggs be putted in one basket? A portfolio model based on investor sentiment and inertial thinking," Economic Modelling, Elsevier, vol. 35(C), pages 682-688.
  2. Luigi Guiso & Paolo Sodini, 2012. "Household Finance. An Emerging Field," EIEF Working Papers Series 1204, Einaudi Institute for Economics and Finance (EIEF), revised Mar 2012.
  3. Hui Chen & Nengjiu Ju & Jianjun Miao, . "Dynamic Asset Allocation with Ambiguous Return Predictability," Boston University - Department of Economics - Working Papers Series wp2009-015, Boston University - Department of Economics.
  4. David Chambers & Elroy Dimson, 2013. "Retrospectives: John Maynard Keynes, Investment Innovator," Journal of Economic Perspectives, American Economic Association, vol. 27(3), pages 213-28, Summer.
  5. Marcello Basili & Luca Pratelli, 2013. "Aggregation of not necessarily independent opinions," Department of Economics University of Siena 677, Department of Economics, University of Siena.

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