Ambiguity Aversion and Underdiversification

Abstract

We examine asset allocation decisions under smooth ambiguity aversion when an investor has a prior degree of belief in the domestic capital asset pricing model (CAPM). Different from a Bayesian approach, the investor separately relies on the conditional distribution of returns and on the posterior over parameters to make decisions, rather than on the predictive distribution of returns that integrates priors and likelihood information. We find that in the perspective of U.S. investors, ambiguity aversion generates strong home bias in equity holdings, regardless of beliefs in the CAPM or risk aversion. Results become stronger under regime-switching investment opportunities.