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

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. For example, multi-period investments with negative risk premia can be profitable, there can be infinite demand for risky securities by risk averse investors, settings exist where risk averse investors should not diversify, and demand for mutual funds with negative alphas may be rational.

Number of Pages in PDF File: 48

Keywords: Bayesian, Multi-period Investment, Nonlinear Estimation

JEL Classification: C11, G11

working papers series