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

  • 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)

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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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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  1. 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).
  2. Bryan Routledge & Stanley Zin, 2009. "Model Uncertainty and Liquidity," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 543-566, October.
  3. Massimo Massa & Andrei Simonov, 2006. "Hedging, Familiarity and Portfolio Choice," Review of Financial Studies, Society for Financial Studies, vol. 19(2), pages 633-685.
  4. John Y. Campbell, 2006. "Household Finance," Journal of Finance, American Finance Association, vol. 61(4), pages 1553-1604, 08.
  5. Laurent E. Calvet & John Y. Campbell & Paolo Sodini, 2006. "Down or Out: Assessing the Welfare Costs of Household Investment Mistakes," NBER Working Papers 12030, National Bureau of Economic Research, Inc.
  6. 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.
  7. 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.
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