Limited Diversification, Portfolio Inertia, and Ambiguous Correlation

We study the effects of correlation ambiguity on portfolio choice in a market with multiple risky assets. We find that the optimal portfolio contains only a fraction of risky assets under correlation ambiguity, and in particular, just one risky asset enters the optimal portfolio if the level of correlation ambiguity is substantial. We demonstrate that the optimal portfolio does not change when assets' Sharpe ratios change within a range. Our ambiguity-aversion model on correlation explains both the limited diversification property and the portfolio inertia property in household portfolios and retirement accounts. We further provide simulation evidences of the limited diversification and portfolio inertia feature of the optimal portfolio by a broad set of stocks. This paper suggests that correlation ambiguity has important implications for portfolio choice