Keynes Meets Markowitz: The Tradeoff between Familiarity and Diversification

44 Pages Posted: 16 Feb 2009 Last revised: 16 Sep 2009

See all articles by Phelim P. Boyle

Phelim P. Boyle

Wilfrid Laurier University - School of Business & Economics; University of Waterloo

Lorenzo Garlappi

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

Raman Uppal

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

Tan Wang

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

Multiple version iconThere are 3 versions of this paper

Date Written: February 14, 2009

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

Suggested Citation

Boyle, Phelim P. and Garlappi, Lorenzo and Uppal, Raman and Wang, Tan, Keynes Meets Markowitz: The Tradeoff between Familiarity and Diversification (February 14, 2009). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1343387 or http://dx.doi.org/10.2139/ssrn.1343387

Phelim P. Boyle

Wilfrid Laurier University - School of Business & Economics ( email )

Waterloo, Ontario N2L 3C5
Canada
519 884 1970 (Phone)
519 888 1015 (Fax)

University of Waterloo

Waterloo, Ontario N2L 3G1
Canada

Lorenzo Garlappi (Contact Author)

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

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

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

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

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