Correlation Ambiguity

43 Pages Posted: 20 Nov 2015 Last revised: 29 Jun 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: June 27, 2017

Abstract

We show that correlation ambiguity has significant effects on portfolio choice. The optimal portfolio can contain only one risky asset (anti-diversification). More generally, the optimal portfolio contains only a subset of available risky assets. With 100 available stocks randomly selected from the S&P 500, the optimal portfolio contains less than 20 stocks on average. Thus, correlation ambiguity provides an explanation for under-diversification documented in empirical studies. Even though the optimal portfolio under correlation ambiguity is less diversified than the standard mean-variance portfolio, it is less risky in the sense that it has smaller variance and fewer extremely large positions.

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

JEL Classification: G11

Suggested Citation

Liu, Jun and Zeng, Xudong, Correlation Ambiguity (June 27, 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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