Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach

Posted: 29 Feb 2008

See all articles by Lorenzo Garlappi

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Tan Wang

University of British Columbia (UBC) - Division of Finance; China Academy of Financial Research (CAFR)

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: January 2007

Abstract

We develop a model for an investor with multiple priors and aversion to ambiguity. We characterize the multiple priors by a "confidence interval" around the estimated expected returns and we model ambiguity aversion via a minimization over the priors. Our model has several attractive features: (1) it has a solid axiomatic foundation; (2) it is flexible enough to allow for different degrees of uncertainty about expected returns for various subsets of assets and also about the return-generating model; and (3) it delivers closed-form expressions for the optimal portfolio. Our empirical analysis suggests that, compared with portfolios from classical and Bayesian models, ambiguity-averse portfolios are more stable over time and deliver a higher out-of sample Sharpe ratio. (JEL G11)

Suggested Citation

Garlappi, Lorenzo and Wang, Tan and Uppal, Raman, Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach (January 2007). The Review of Financial Studies, Vol. 20, Issue 1, pp. 41-81, 2007. Available at SSRN: https://ssrn.com/abstract=1093503 or http://dx.doi.org/10.1093/rfs/hhl003

Lorenzo Garlappi (Contact Author)

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Tan Wang

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-9414 (Phone)
604-822-8521 (Fax)

China Academy of Financial Research (CAFR)

1954 Huashan Road
Shanghai P.R.China, 200030
China

Raman Uppal

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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