Abstract
In dealership markets, asymmetric information feeds through to higher transaction costs as dealers adjust their bid-ask spreads to compensate for anticipated losses. In this paper, we show that the presence of asymmetric information can also provide a positive externality to those market participants who operate in multiple markets-portfolio managers. Specifically, insiders lower the estimation errors of portfolio selection methods, thus improving asset allocation. We develop multiple artificial markets, in which portfolio managers trade alongside informed and uniformed speculators, and we contrast the performance of ‘volatility timing’ — a method that relies on efficient price discovery — with that of ‘naive diversification’. Volatility timing is shown to consistently outperform naive diversification on a risk-adjusted basis.
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