Keynes Meets Markowitz: The Tradeoff between Familiarity and Diversification

Abstract

We develop a model of portfolio choice capable of nesting the views of Keynes, advocating concentration in a few familiar assets, and Markowitz, advocating diversification across all available assets. In the model, the return distributions of risky assets are ambiguous, and investors are averse to this ambiguity. The model allows for different degrees of familiarity for various assets and captures the tradeoff between concentration and diversification. The models shows that if investors are not familiar about a particular asset, then they hold a diversified portfolio, as advocated by Markowitz. On the other hand, if investors are familiar about a particular asset, they tilt their portfolio toward that asset, while continuing to diversify by holding the other assets in the market. And, if investors are familiar about a particular asset and sufficiently ambiguous about all other assets, then they hold only the familiar asset, as Keynes would have advocated. Finally, if investors are sufficiently ambiguous about all risky assets, then they will not participate at all in the equity market. The model shows that even when the number of assets available for investment is very large, investors continue to hold familiar assets, and an increase in correlation between familiar assets and the rest of the market leads to an increase in the allocation to familiar assets, as we observe empirically during periods of financial crises. We also show how beta and the risk premium of stocks can depend on both systematic and unsystematic volatility. Our model predicts also that, when the aggregate level of ambiguity in the economy is large, investors increase concentration in the assets with which they are more familiar (flight to familiarity), even if these happen to be assets with a higher risk or lower expected return.

Keywords: Investment, portfolio choice, ambiguity, robust control

JEL Classification: G11, G12, G23, D81