Model Ambiguity versus Model Misspecification in Dynamic Portfolio Choice and Asset Pricing

66 Pages Posted: 29 Oct 2022 Last revised: 14 Feb 2023

See all articles by Anne Balter

Anne Balter

Tilburg University; Netspar

Pascal J. Maenhout

INSEAD - Finance

Hao Xing

Boston University - Questrom School of Business

Date Written: February 13, 2023

Abstract

We study aversion to model ambiguity and misspecification in dynamic portfolio choice. Investors with relative risk aversion gamma > 1 fear return persistence, while risk-tolerant investors (0 < gamma < 1) fear return mean reversion, to confront model misspecification concerns when facing a model with IID returns. The intuition is that risk-averse (risk-tolerant) investors who are keen to hedge (speculate) intertemporally worry about an endogenous worst-case misspecification where returns persist (mean-revert) so that hedging (speculation) is impossible. A log investor is myopic and unaffected by model misspecification, therefore only worrying about model ambiguity among IID models. Rather than the multiplier approach of Hansen and Sargent (2001) we utilize a constraint approach, preserving homotheticity and tractability. Our model can explain evidence for the experience hypothesis, for nonparticipation in equity markets, as well as for extrapolative return expectations. In equilibrium, we show that model misspecification, unlike model ambiguity, can generate excess volatility, even with IID fundamentals.

Suggested Citation

Balter, Anne and Maenhout, Pascal J. and Xing, Hao, Model Ambiguity versus Model Misspecification in Dynamic Portfolio Choice and Asset Pricing (February 13, 2023). Available at SSRN: https://ssrn.com/abstract=4259774 or http://dx.doi.org/10.2139/ssrn.4259774

Anne Balter (Contact Author)

Tilburg University ( email )

P.O. Box 90153
Tilburg, DC Noord-Brabant 5000 LE
Netherlands

Netspar ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Pascal J. Maenhout

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

Hao Xing

Boston University - Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA MA 02215
United States

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