43 Pages Posted: 20 Nov 2015 Last revised: 16 Sep 2016
Date Written: September 15, 2016
Most papers on ambiguity aversion in the setting of portfolio choice focus on expected return. In his paper, we study portfolio choice under ambiguity aversion to correlation. We show that when ambiguity is large, the optimal portfolio consists of only one risky asset. More generally, the optimal portfolio may contain only a part of all available risky assets. Even though the optimal portfolio is less diversified we show that it is less risky in the sense that it has smaller variance and fewer extreme positions than the standard mean-variance portfolio. With 100 stocks randomly selected from the S&P 500, on average, approximately 20 stocks will be held in the optimal portfolio when sets of ambiguous correlations are given by 95% confidence intervals. Our results suggest that correlation ambiguity has important implications in that it generates fewer extreme portfolio weights and may provide an explanation for under-diversification documented in empirical studies.
Keywords: potfolio choice, under-diversification, ambiguity
JEL Classification: G11
Suggested Citation: Suggested Citation