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Dynamic Asset Allocation with Ambiguous Return Predictability

  • Hui Chen

    ()

    (MIT Sloan School of Management)

  • Nengjiu Ju

    ()

    (Department of Finance, the Hong Kong University of Science and Technology)

  • Jianjun Miao

    ()

    (Department of Economics, Boston University)

We study an investor's optimal consumption and portfolio choice problem when he confronts with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor's aversion to model uncertainty. The investor deals with specification doubts by slanting his beliefs about submodels of returns pessimistically, causing his investment strategy to be more conservative than the Bayesian strategy. This effect is large for extreme values of the predictive variable. Unlike in the Bayesian framework, model uncertainty induces a hedging demand, which may cause the investor to decrease his stock allocations sharply and then increase with his prior probability of IID returns. Adopting suboptimal investment strategies by ignoring model uncertainty can lead to sizable welfare costs.

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Paper provided by Boston University - Department of Economics in its series Boston University - Department of Economics - The Institute for Economic Development Working Papers Series with number dp-179.

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Length: 44
Date of creation: Sep 2008
Date of revision: Feb 2009
Handle: RePEc:bos:iedwpr:dp-179
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