Ambiguous Information, Portfolio Inertia, and Excess Volatility



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    • Illeditsch is with The Wharton School, University of Pennsylvania. I am still looking for words to express my gratitude to my dissertation chair Kerry Back. I would like to thank Campbell Harvey (the Editor) and an anonymous associate editor and referee for their comments, which substantially improved the paper. I would also like to thank Philip Bond; Domenico Cuoco; Larry Epstein; Michael Gallmeyer; Neal Galpin; Jayant Ganguli; Itay Goldstein; Christian Heyerdahl-Larsen; Shane Johnson; Dmitry Livdan; Marcel Rindisbacher; Klaus Ritzberger; Bryan Routledge; Francesco Sangiorgi; Martin Schneider; Nicholas Souleles; Robert Stambaugh; Tommy Stamland; Semih Tartaroglu; Raman Uppal; Julie Wu; Amir Yaron; Motohiro Yogo; Josef Zechner; Stanley Zin; seminar participants at Mays Business School, Rotman School of Management, Stern School of Business, Wharton School, Carnegie Mellon, University of Amsterdam, Tilburg University, Warwick Business School, Norwegian School of Economics and Business Administration (NHH), Norwegian School of Management (BI), Vienna Graduate School of Finance, Columbia University; and participants at the New Stars in Finance Conference in Madrid, the Annual Meeting of the Society for Economic Dynamics in Istanbul, the Annual Meeting of the European Finance Association in Bergen, and the Workshop on Risk, Ambiguity, and Decisions in Honor of Daniel Ellsberg in Vienna for helpful comments and suggestions. I am also very grateful for the generous support of the Mays Business School during my Ph.D. education. The paper previously circulated under the title “Ambiguous Information, Risk Aversion, and Asset Pricing.”


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, investors may not react to price changes even if 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.