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Jensen's Inequality, Parameter Uncertainty, and Multi-period Investment

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  • Mark Grinblatt
  • Juhani T. Linnainmaa

Abstract

Classical approaches to estimation and decisions requiring estimation often are at odds. When values critical to the decision are convex or concave functions of unknown parameters, the statistician's estimation error adjustments are the opposite of what is appropriate for the decision. We illustrate the conflict by studying multi-period investment problems. The proper application of Jensen's inequality to the decision turns finance intuition on its head: Multi-period investments with negative risk premia can be profitable, risk-averse investors can have infinite demand for risky securities, settings exist in which risk-averse investors should not diversify, and demand for mutual funds with negative alphas may be rational.

Suggested Citation

  • Mark Grinblatt & Juhani T. Linnainmaa, 2011. "Jensen's Inequality, Parameter Uncertainty, and Multi-period Investment," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 1(1), pages 1-34.
    • Handle: RePEc:oup:rasset:v:1:y:2011:i:1:p:1-34.
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    File URL: http://hdl.handle.net/10.1093/rapstu/raq001
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    More about this item

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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