Model Ambiguity versus Model Misspecification in Dynamic Portfolio Choice and Asset Pricing

We study aversion to model ambiguity and misspecification in dynamic portfolio choice. Investors with relative risk aversion gamma > 1 fear return persistence, while risk-tolerant investors (0 < gamma < 1) fear return mean reversion, to confront model misspecification concerns when facing a model with IID returns. The intuition is that risk-averse (risk-tolerant) investors who are keen to hedge (speculate) intertemporally worry about an endogenous worst-case misspecification where returns persist (mean-revert) so that hedging (speculation) is impossible. A log investor is myopic and unaffected by model misspecification, therefore only worrying about model ambiguity among IID models. Rather than the multiplier approach of Hansen and Sargent (2001) we utilize a constraint approach, preserving homotheticity and tractability. Our model can explain evidence for the experience hypothesis, for nonparticipation in equity markets, as well as for extrapolative return expectations. In equilibrium, we show that model misspecification, unlike model ambiguity, can generate excess volatility, even with IID fundamentals