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Correlation Ambiguity and Under-Diversification

48 Pages Posted: 20 Nov 2015 Last revised: 13 Sep 2017

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Xudong Zeng

Shanghai University of Finance and Economics, School of Finance

Date Written: September 7, 2017

Abstract

We study effects of correlation ambiguity on portfolio choice when the number of risky assets is large. We find that the optimal portfolio contains only a fraction of available risky assets. With 100 stocks randomly selected from the S&P 500, less than 20 stocks will be held in the optimal portfolio. Thus, correlation ambiguity provides an explanation for under-diversification documented in empirical studies. In particular, correlation ambiguity can generate anti-diversification in the sense that the optimal portfolio consists of only one risky asset. Even though the optimal portfolio under correlation ambiguity is less diversified, it is less risky in the sense that it has smaller variance and fewer extremely large positions than the standard mean-variance portfolio. Our results suggest that correlation ambiguity has important implications for portfolio choice.

Keywords: potfolio choice, under-diversification, ambiguity, correlation, mean-variance

JEL Classification: G11

Suggested Citation

Liu, Jun and Zeng, Xudong, Correlation Ambiguity and Under-Diversification (September 7, 2017). Available at SSRN: https://ssrn.com/abstract=2692692. or http://dx.doi.org/10.2139/ssrn.2692692

Jun Liu (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

Xudong Zeng

Shanghai University of Finance and Economics, School of Finance ( email )

777 Guoding Road
Shanghai, Shanghai 200433
China

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