Ambiguous Information, Portfolio Inertia, and Excess Volatility

Abstract

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.