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Dynamic Asset Allocation with Ambiguous Return Predictability

46 Pages Posted: 2 Mar 2009 Last revised: 14 Apr 2011

Hui Chen

Massachusetts Institute of Technology; National Bureau of Economic Research (NBER)

Nengjiu Ju

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Jianjun Miao

Boston University - Department of Economics

Date Written: April 11, 2011

Abstract

We study an investor's optimal consumption and portfolio choice problem when he is confronted with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor's aversion to model uncertainty. The investor deals with specification doubts by slanting his beliefs about submodels of returns pessimistically, causing his investment strategy to be more conservative than the Bayesian strategy. This effect is especially strong when the submodel with a low Bayesian probability delivers a much smaller continuation value. Unlike in the Bayesian framework, the hedging demand against model uncertainty may cause the investor's stock allocation to decrease sharply given a small doubt of return predictability, even though the predictive variable is large. Adopting the Bayesian strategy can lead to sizable welfare costs for an ambiguity-averse investor, especially when he has a strong prior of return predictability.

Keywords: generalized recursive ambiguity utility, ambiguity aversion, model uncertainty, learning, portfolio choice, robustness, return predictability

JEL Classification: G11

Suggested Citation

Chen, Hui and Ju, Nengjiu and Miao, Jianjun, Dynamic Asset Allocation with Ambiguous Return Predictability (April 11, 2011). AFA 2010 Atlanta Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1351609 or http://dx.doi.org/10.2139/ssrn.1351609

Hui Chen

Massachusetts Institute of Technology ( email )

50 Memorial Drive
Cambridge, MA 02142
United States
617-324-3896 (Phone)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Nengjiu Ju

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Jianjun Miao (Contact Author)

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-6675 (Phone)

HOME PAGE: http://people.bu.edu/miaoj

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