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Ambiguous Information, Portfolio Inertia, and Excess Volatility

54 Pages Posted: 5 May 2010 Last revised: 7 Dec 2011

Philipp K. Illeditsch

University of Pennsylvania - Finance Department

Date Written: March 2011

Abstract

I study the effects of risk and ambiguity (Knightian uncertainty) on optimal portfolios and equilibrium asset prices when investors receive information that is difficult to link to fundamentals. I show that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility. Specifically, when news is surprising, then investors may not react to price changes although there are no transaction costs or other market frictions. Moreover, I show that small shocks to cash flow news, asset betas, or market risk premia may lead to drastic changes in the stock price and hence to excess volatility.

Keywords: Learning from Ambiguous Signals, Portfolio Inertia, Excess Volatility, Ambiguity Aversion, Knightian Uncertainty, Heterogenous Agents

JEL Classification: D81, D83, G11, G12

Suggested Citation

Illeditsch, Philipp K., Ambiguous Information, Portfolio Inertia, and Excess Volatility (March 2011). Journal of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1600299

Philipp K. Illeditsch (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-3477 (Phone)

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