Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach

Lorenzo Garlappi, Raman Uppal and Tan Wang

The Review of Financial Studies, 2007, vol. 20, issue 1, 41-81

Abstract: We develop a model for an investor with multiple priors and aversion to ambiguity. We characterize the multiple priors by a "confidence interval" around the estimated expected returns and we model ambiguity aversion via a minimization over the priors. Our model has several attractive features: (1) it has a solid axiomatic foundation; (2) it is flexible enough to allow for different degrees of uncertainty about expected returns for various subsets of assets and also about the return-generating model; and (3) it delivers closed-form expressions for the optimal portfolio. Our empirical analysis suggests that, compared with portfolios from classical and Bayesian models, ambiguity-averse portfolios are more stable over time and deliver a higher out-of sample Sharpe ratio. (JEL G11) Copyright 2007, Oxford University Press.

Date: 2007
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Working Paper: Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach (2005)
Working Paper: Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach (2005)
Working Paper: Portfolio Selection with Parameter and Model Uncertainty: A Multi-Prior Approach (2004)
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