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RFS Advance Access originally published online on April 2, 2004
Review of Financial Studies 2004 17(4):951-983; doi:10.1093/rfs/hhh003
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The Review of Financial Studies Vol. 17, No. 4 © 2004 The Society for Financial Studies; all rights reserved.

Robust Portfolio Rules and Asset Pricing

Pascal J. Maenhout
INSEAD

Address correspondence to Pascal Maenhout, Finance Department, INSEAD, Boulevard de Constance, 77305 Fontainebleau Cedex, France, or e-mail: pascal.maenhout{at}insead.edu

I present a new approach to the dynamic portfolio and consumption problem of an investor who worries about model uncertainty (in addition to market risk) and seeks robust decisions along the lines of Anderson, Hansen, and Sargent (2002). In accordance with max-min expected utility, a robust investor insures against some endogenous worst case. I first show that robustness dramatically decreases the demand for equities and is observationally equivalent to recursive preferences when removing wealth effects. Unlike standard recursive preferences, however, robustness leads to environment-specific "effective" risk aversion. As an extension, I present a closed-form solution for the portfolio problem of a robust Duffie-Epstein-Zin investor. Finally, robustness increases the equilibrium equity premium and lowers the risk-free rate. Reasonable parameters generate a 4% to 6% equity premium.


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