1 Portfolio Choice Under Ambiguity

2015

This paper represents an intersection between two lines of research. The first is portfolio choice theory, which underlies much of finance; the second is the elicitation of preferences under uncertainty. The theory of the behaviour of financial markets builds heavily on portfolio choice theory; until recently this has assumed that preferences are of a particularly simple kind. In contrast research on preferences has revealed that people have more sophisticated preferences. This paper tries to bring the two fields together by investigating, in a portfolio choice context, the preferences that are revealed by decisions. In the second of these two fields, researchers are increasingly using allocation problems to elicit the preferences of subjects, believing that such problems are more informative, and perhaps more natural, than other elicitation methods. At the same time portfolio choice theory is itself concerned with an allocation problem. Usually in experimental finance the allocatio...

2016

Neoclassical economic theory assumes that when agents tackle dynamic decisions under ambiguity, preferences are represented by Expected Utility and prior beliefs are updated according to Bayes rule, upon the arrival of partial information. Nevertheless, when one considers non-neutral ambiguity attitudes, either the axiom of dynamic consistency or of consequentialism should be relaxed. We report the results of a new experiment, designed to investigate how people behave in a dynamic choice problem under ambiguity, where decisions are made both before and after the resolution of some uncertainty. We study which of the two rationality axioms people violate, along with the question of whether this violation is part of a conscious planning strategy or not. The combination of the two, allows us to classify subjects to three behavioural types: resolute, naive and sophisticated. Using data from a portfolio choice experiment where ambiguity is represented in a transparent and non-manipulable ...

Review of Finance, 2015

Investors do not hold optimal portfolios. We use an experimental method to isolate factors that compel individuals to hold optimal portfolios. Our design includes two risky assets with perfectly negatively correlated payoffs so that all risk can be eliminated. We find that participants' holdings approach optimal portfolios only under very specific conditions: the variance cost of holding an imbalanced portfolio is substantial and feedback on period-by-period outcomes is suppressed (eliminating the impact of cognitive biases resulting from misperceptions of randomness). JEL classification: C92, G15 * Financial support of Agnes Scott College, the Coles College of Business, and the Federal Reserve Bank of Atlanta is gratefully acknowledged. The authors thank Sean Cuevo, Lori Shefchik, and Yujia Wang for research assistance, Kevin Ackaramongkolrotn and Todd Swarthout for technical assistance, and Burton Hollifield (the editor), an anonymous referee, Brian Kluger, Jim Steely, Adam Vitalis, and workshop participants at the University of Arkansas at Little Rock, University of South Carolina, and Wilfrid Laurier University for helpful comments. The authors also thank Jim Cox and the EXperimental Economics CENter (EXCEN) at the Andrew Young School of Policy Studies at Georgia State University for use of their experimental laboratory.

2010

We study the following basic intuition: when faced with a decision how to split their investment between a risky lottery and an asset with a fixed return, people increase the proportion invested in the risky option the more they like the lottery. We find counter-examples to this, and in fact we find no simple relation between preferences between lotteries and the fraction invested in them. We use three well-documented biases (ambiguity aversion, the illusion of control and myopic loss aversion) to show this. First we replicate the previous results in a laboratory experiment with financial incentives, and then test whether participants are willing to explicitly pay a small sum of money in line with the bias (pay for less ambiguity, more perceived control, or more frequent information about portfolio performance). We then study how portfolio choice depends on these biases.

International Multidisciplinary Scientific Conferences on Social Sciences and Arts, SGEM2014, Section Finance, Conference Proceedings, Volume II, Albena, Bulgaria, 1-10 September 2014, pp. 75-79, ISBN 978-619-7105-26-1, DOI: 10.5593/sgemsocial2014B22, 2014

According to the behavioral finance theory, agents act coherently with the Kahneman and Tversky prospect paradigms and may violate those dictated by the rational expected utility. From the point of view of real financial markets’ applications, a key question concerns how to eliciting the financial professionals’ risk preferences. In this contribution we propose the benchmarking procedure originally set up by Castagnoli and LiCalzi (1996) and Bordley and LiCalzi (2000) that couples sound axiomatic fundamentals with a user-friendly language. According to the benchmarking modelling, to maximizing the expected cardinal utility is equivalent to maximizing the probability to meet a (uncertain) goal. It follows that the subjective preferences under risk can be expressed in terms of the probability of matching financial benchmarks. Since practitioners may feel more comfortable in answering questions involving perceived probability of meeting commitments than expressing preferences on lotteries’ outcomes, the use of the benchmarking modelling is expected to reduce inconsistency in questionnaires.

Review of Financial …, 2007

This paper studies the impact of ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitude toward ambiguity is heterogeneous in the population, just as attitude toward risk is heterogeneous in the population, but that heterogeneity in attitude toward ambiguity has different implications than heterogeneity in attitude toward risk. Specifically, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This leads to a wider range of state price densities and to potential reversals of ranking of state price-probability ratios relative to aggregate wealth. In addition, the distribution of holdings will have a new mode, with highly ambiguity averse agents holding securities with ambiguous payoffs in equal proportions. Under pure risk, the distribution of holdings has a single mode equal to the market portfolio weight. Experiments confirm the theoretical predictions. While price patterns often look little different from those under pure risk, portfolio choices display strong effects from the presence of ambiguity. The experiments also suggest a positive correlation between risk aversion and ambiguity aversion, which may explain the "value effect" in field data. † We are grateful for comments to seminar audiences at CIRANO, U.C. Irvine, Kobe University, Collegio

Review of Financial …, 2010

This paper studies the impact of ambiguity and ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitudes toward ambiguity are heterogeneous across the population, just as attitudes toward risk are heterogeneous across the population, but that heterogeneity of attitudes toward ambiguity has different implications than heterogeneity of attitudes toward risk. In particular, when some state probabilities are not known, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This suggests a different cross-section of portfolio choices, a wider range of state price/probability ratios and different rankings of state price/probability ratios than would be predicted if state probabilities were known. Experiments confirm all of these suggestions. Our findings contradict the claim that investors who have cognitive biases do not affect prices because they are infra-marginal: ambiguity averse investors have an indirect effect on prices because they change the per-capita amount of risk that is to be shared among the marginal investors. Our experimental data also suggest a positive correlation between risk aversion and ambiguity aversion that might explain the "value effect" in historical data.

2006

Most of the economics and finance literature assumes that individual agents obey the Savage axioms; that is, they maximize expected utility according to subjective priors. However, Knight, Ellsberg and others argue that individual agents distinguish between risk (known probabilities) and uncertainty, or ambiguity (unknown probabilities), and that individual agents may display aversion to ambiguity, just as they display aversion to risk. This paper studies the impact of ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitude toward ambiguity is heterogeneous in the population, just as attitude toward risk is heterogeneous in the population, but that heterogeneity in attitude toward ambiguity has different implications than heterogeneity in attitude toward risk: agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This leads to a wider range of state price densities and to potential reversals of ranking of state price densities. Experiments confirm the theoretical predictions.

Journal of Risk and Uncertainty

This paper is about behaviour under ambiguity-that is, a situation in which probabilities either do not exist or are not known. Our objective is to find the most empirically valid of the increasingly large number of theories attempting to explain such behaviour. We use experimentally-generated data to compare and contrast the theories. The incentivised experimental task we employed was that of allocation: in a series of problems we gave the subjects an amount of money and asked them to allocate the money over three accounts, the payoffs to them being contingent on a 'state of the world' with the occurrence of the states being ambiguous. We reproduced ambiguity in the laboratory using a Bingo Blower. We fitted the most popular and apparently empirically valid preference functionals [Subjective Expected Utility (SEU), MaxMin Expected Utility (MEU) and α-MEU], as well as Mean-Variance (MV) and a heuristic rule, Safety First (SF). We found that SEU fits better than MV and SF and only slightly worse than MEU and α-MEU.