Ambiguity Aversion and Under-diversification
53 Pages Posted: 25 Jan 2014 Last revised: 27 Aug 2014
Date Written: March 1, 2014
We examine asset allocation decisions under smooth ambiguity aversion when an investor has a prior degree of belief in an asset pricing model (e.g., the domestic CAPM). Different from a Bayesian approach, the investor separately relies on the conditional distribution of returns and on the posterior over parameters to make decisions, rather than on the predictive distribution of returns that integrates priors and likelihood information. We find that in the perspective of US investors, ambiguity aversion generates strong home bias in equity holdings, regardless of beliefs in the CAPM or risk aversion. Results become stronger under regime-switching investment opportunities.
Keywords: Ambiguity aversion, Bayesian portfolio analysis, CAPM, Smooth ambiguity
JEL Classification: C61, D81, G11
Suggested Citation: Suggested Citation