Ambiguity, Prudence, and Optimal Portfolio Choice: Beyond Robust Mean-Variance Analysis

Abstract

I extend the robust mean-variance portfolio analysis proposed by Maccheroni et al. (2013) by examining how ambiguity prudence affects the optimal stock allocation when the investor evaluates portfolios as described by the smooth ambiguity model. Ambiguity prudence captures an aversion toward model uncertainty that increases the more the investor believes that unfavorable events are likely to occur. I derive a higher-order approximation of the certainty equivalent to separate the contributions of preferences and beliefs to payoff valuation. I analyze two portfolio problems to show how ambiguity prudence generates non-linearities in the investor's valuation, which induce sizable implications for the optimal portfolio composition.

Keywords: Ambiguity, portfolio, prudence, robustness, smooth ambiguity model

JEL Classification: D80, D81, G11