Return Predictability under Knightian Uncertainty

The predictability of stock and bond excess returns is investigated from an investment perspective in the presence of Knightian uncertainty. Uncertainty about the return distribution is formalized with the maxmin expected utility approach of Gilboa and Schmeidler (1989). It is analyzed how risk and uncertainty aversion di¤er in their e¤ects on optimal portfolio choice. Most importantly, it is shown that the two-fund separation theorem does only hold when all investors have the same degree of uncertainty aversion. The portfolio choice model is used to historically evaluate the in-sample and out-of-sample performance of investment strategies which are based on conditional expectations about the ...rst and second moments of excess returns. While conditioning information yields small economic pro...ts on an in-sample basis, it deteriorates the risk-adjusted performance out-of-sample when compared with a strategy based on unconditional expectations. This ...nding holds for uncertainty neutral and averse investors alike. Utility gain calculations assess the value of the di¤erent information variables used to form return expectations as well as the relative value of information about the ...rst and second moments of asset returns. One result is that uncertainty averse investors evaluate the same conditioning information qualitatively di¤erent than uncertainty neutral investors.