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Keynes Meets Markowitz: The Trade-Off Between Familiarity and Diversification

Author

Listed:
  • Phelim Boyle

    (School of Business and Economics, Wilfrid Laurier University, Waterloo, Ontario N2L 3C5, Canada)

  • Lorenzo Garlappi

    (Sauder School of Business, University of British Columbia, Vancouver, British Columbia V6T 1Z2, Canada)

  • Raman Uppal

    (EDHEC Business School, Lille, 59057 Roubaix, France)

  • Tan Wang

    (China Academy of Financial Research, 200030 Shanghai, People's Republic of China; and Sauder School of Business, University of British Columbia, Vancouver, British Columbia V6T 1Z2, Canada)

Abstract
We develop a model of portfolio choice to nest the views of Keynes, who advocates concentration in a few familiar assets, and Markowitz, who advocates diversification. We use the concepts of ambiguity and ambiguity aversion to formalize the idea of an investor's "familiarity" toward assets. The model shows that for any given level of expected returns, the optimal portfolio depends on two quantities: relative ambiguity across assets and the standard deviation of the expected return estimate for each asset. If both quantities are low, then the optimal portfolio consists of a mix of familiar and unfamiliar assets; moreover, an increase in correlation between assets causes an investor to increase concentration in familiar assets (flight to familiarity). Alternatively, if both quantities are high, then the optimal portfolio contains only the familiar asset(s), as Keynes would have advocated. In the extreme case in which both quantities are very high, no risky asset is held (nonparticipation). This paper was accepted by Brad Barber, Teck Ho, and Terrance Odean, special issue editors.

Suggested Citation

  • Phelim Boyle & Lorenzo Garlappi & Raman Uppal & Tan Wang, 2012. "Keynes Meets Markowitz: The Trade-Off Between Familiarity and Diversification," Management Science, INFORMS, vol. 58(2), pages 253-272, February.
    • Handle: RePEc:inm:ormnsc:v:58:y:2012:i:2:p:253-272
    DOI: 10.1287/mnsc.1110.1349
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    More about this item

    Keywords

    investment; portfolio choice; ambiguity; robust control; underdiversification;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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