Ambiguity Aversion and Underdiversification

Hening Liu, Massimo Guidolin

Research output: Contribution to journalArticlepeer-review

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 a Bayesian approach, the investor separately relies on the conditional distribution of returns and on the posterior over parameters to make decisions, rather than on the predictive distribution of returns that integrates priors and likelihood information. We find that in the perspective of US investors, ambiguity aversion generates strong home bias in equity holdings, regardless of beliefs in the CAPM or risk aversion. Results become stronger under regime-switching investment opportunities.
Original languageEnglish
Pages (from-to)1297-1323
JournalJournal of Financial and Quantitative Analysis
Volume51
Issue number4
Early online date1 Nov 2016
DOIs
Publication statusPublished - 2016

Keywords

  • Ambiguity aversion, Bayesian portfolio analysis, CAPM, Smooth ambiguity

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