Optimal investment with stochastic interest rates and ambiguity

This paper studies the optimal dynamic asset allocation between bonds, stocks, and cash of an ambiguity averse investor. While ambiguity aversion possibly leads to non-participation in the stock market, the investor always invests in bonds to hedge interest rate risk, showing that non-participation results prevail for the stock market but do not apply to the bond market. The bond-stock ratio increases in the investor's risk aversion whenever it is well-defined, providing a robust explanation for the asset allocation puzzle. An application to the US market yields an investment in stocks for speculative reasons and an investment in bonds solely for hedging purposes with a bond-stock ratio increasing in the investor's risk aversion. Quantitatively, ambiguity aversion leads to less leveraged portfolios and a shift to a large fraction of wealth held in cash towards the investor's time horizon.