Model Misspecification and Underdiversification

Authors: Uppal R.¹; Wang T.²

Source: The Journal of Finance, Volume 58, Number 6, December 2003 , pp. 2465-2486(22)

Publisher: Blackwell Publishing

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Abstract:

In this paper, we study intertemporal portfolio choice when an investor accounts explicitly for model misspecification. We develop a framework that allows for ambiguity about not just the joint distribution of returns for all stocks in the portfolio, but also for different levels of ambiguity for the marginal distribution of returns for any subset of these stocks. We find 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 underdiversified relative to the standard mean-variance portfolio.

Document Type: Research article

DOI: 10.1046/j.1540-6261.2003.00612.x

Affiliations: 1: London Business School and CEPR 2: University of British Columbia

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