Ambiguous Information, Portfolio Inertia, and Excess Volatility
54 Pages Posted: 5 May 2010 Last revised: 7 Dec 2011
Date Written: March 2011
I study the effects of risk and ambiguity (Knightian uncertainty) on optimal portfolios and equilibrium asset prices when investors receive information that is difficult to link to fundamentals. I show that the desire of investors to hedge ambiguity leads to portfolio inertia and excess volatility. Specifically, when news is surprising, then investors may not react to price changes although there are no transaction costs or other market frictions. Moreover, I show that small shocks to cash flow news, asset betas, or market risk premia may lead to drastic changes in the stock price and hence to excess volatility.
Keywords: Learning from Ambiguous Signals, Portfolio Inertia, Excess Volatility, Ambiguity Aversion, Knightian Uncertainty, Heterogenous Agents
JEL Classification: D81, D83, G11, G12
Suggested Citation: Suggested Citation