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Ambiguity Aversion and Under-diversification

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  • Massimo Guidolin
  • Hening Liu

Abstract

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.

Suggested Citation

  • Massimo Guidolin & Hening Liu, 2013. "Ambiguity Aversion and Under-diversification," Working Papers 483, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  • Handle: RePEc:igi:igierp:483
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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