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Information, Expected Utility, and Portfolio Choice

Published online by Cambridge University Press:  12 August 2010

Jun Liu ,
Ehud Peleg  and
Avanidhar Subrahmanyam
Jun Liu
Affiliation:
Cheung-Kong Graduate School of Business and Southwestern University of Finance and Economics of China (visiting), on leave from Rady School of Management, University of California at San Diego, 9500 Gilman Dr., La Jolla, CA 92093. junliu@ucsd.edu.
Ehud Peleg
Affiliation:
Anderson School of Management, University of California at Los Angeles, 110 Westwood Plz., Los Angeles, CA 90095. epeleg@anderson.ucla.edu.
Avanidhar Subrahmanyam
Affiliation:
Anderson School of Management, University of California at Los Angeles, 110 Westwood Plz., Los Angeles, CA 90095. subra@anderson.ucla.edu.
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Abstract

We study the consumption-investment problem of an agent with a constant relative risk aversion preference function, who possesses noisy information about the future prospects of a stock. We also solve for the value of information to the agent in closed form. We find that information can significantly alter consumption and asset allocation decisions. For reasonable parameter ranges, information increases consumption in the vicinity of 25%. Information can shift the portfolio weight on a stock from 0% to around 70%. Thus, depending on the stock beta, the weight on the market portfolio can be considerably reduced with information, causing the appearance of underdiversification. The model indicates that stock holdings of informed agents are positively related to wealth, unrelated to systematic risk, and negatively related to idiosyncratic uncertainty. We also show that the dollar value of information to the agent depends linearly on his wealth and decreases with both the propensity to intermediate consumption and risk aversion.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 5 , October 2010 , pp. 1221 - 1251
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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