Model Misspecification and Under-Diversification

33 Pages Posted: 9 May 2002

See all articles by Tan Wang

Tan Wang

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

Raman Uppal

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

Multiple version iconThere are 2 versions of this paper

Date Written: April 2002

Abstract

In this Paper we develop a model of intertemporal portfolio choice where an investor accounts explicitly for the possibility of model misspecification. This work is motivated by the difficulty in estimating precisely the probability law for asset returns. Our contribution is to develop a framework that allows for ambiguity about the joint distribution of returns for all stocks being considered for the portfolio, and also for different levels of ambiguity for the marginal distribution of returns for any subset of these stocks. We then use this framework to derive in closed-form the optimal portfolio weights of an investor who accounts for model misspecification. We illustrate the model by calibrating it to data on international equity returns. The calibration shows that when the overall ambiguity about the joint distribution of returns is high, then small differences in ambiguity for the marginal return distribution will result in a portfolio that is significantly under-diversified relative to the standard mean-variance portfolio.

Keywords: Portfolio choice, uncertainty, ambiguity, robust control

JEL Classification: D81, G11

Suggested Citation

Wang, Tan and Uppal, Raman, Model Misspecification and Under-Diversification (April 2002). CEPR Discussion Paper No. 3304. Available at SSRN: https://ssrn.com/abstract=311426

Tan Wang

University of British Columbia (UBC) - Division of Finance ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
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604-822-9414 (Phone)
604-822-8521 (Fax)

China Academy of Financial Research (CAFR)

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Shanghai P.R.China, 200030
China

Raman Uppal (Contact Author)

EDHEC Business School ( email )

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Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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