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Ambiguity Aversion and Under-diversification

  • Massimo Guidolin
  • Hening Liu

We examine asset allocation decisions under smooth ambiguity aversion when an investor has a prior degree of belief in an asset pricing model (e.g., the domestic CAPM). Different from the Bayesian portfolio approach, in our model the investor separately relies on the conditional distribution of returns and on the posterior over uncertain parameters to make asset allocation decisions, rather than on the predictive distribution of returns that integrates priors and likelihood information in a single distribution. This is a key feature implied by smooth ambiguity preferences. We find that in the perspective of US investors, ambiguity aversion can generate strong home bias in their equity holdings, regardless of their belief in the domestic CAPM or of their degree of risk aversion. Our results extend and become stronger under regime-switching investment opportunities. JEL Classification: C61; D81; G11. Keywords: Ambiguity aversion, Bayesian portfolio analysis, CAPM, Smooth ambiguity.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 483.

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Date of creation: 2013
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Handle: RePEc:igi:igierp:483
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