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.

We empirically study the economic benefits of giving investors access to index options in the standard portfolio problem, analyzing both expected-utility and nonexpected-utility investors in order to understand who optimally buys and sells options. Using data on S&P 500 index options, CRRA investors find it always optimal to short out-of-the-money puts and at-the-money straddles. The option positions are economically and statistically significant and robust to corrections for transaction costs, margin requirements, and Peso problems. Loss-averse and disappointment-averse investors also optimally hold short option positions. Only with highly distorted probability assessments can we obtain positive portfolio weights for puts (cumulative prospect theory and anticipated utility) and straddles (anticipated utility).

Errors in survey expectations display waves of pessimism and optimism. This paper develops a novel theoretical framework of time-varying beliefs capturing this fact. In our model, dynamic beliefs arise endogenously due to agents’ attitude towards alternative models. Decision-maker’s distorted beliefs generate countercyclical risk aversion, procyclical portfolio weights, and countercyclical equilibrium asset returns. A calibrated version of our model is shown to jointly match salient features in survey data and equity markets.

We study whether option-implied jump risk premia can explain the high observed level of credit spreads. We use a structural jump-diffusion firm value model to assess the level of credit spreads generated by option-implied jump risk premia. Prices and returns of equity index and individual options are used to estimate the jump parameters. We further calibrate the model to historical information on default risk and the equity premium. The results show that incorporating option-implied jump risk premia brings predicted credit spread levels much closer to observed levels. The introduction of jumps also helps to improve the fit of the volatility of credit spreads and equity returns.

This article solves a realistically calibrated life cycle model of consumption and portfolio choice with non-tradable labor income and borrowing constraints. Since labor income substitutes for riskless asset holdings, the optimal share invested in equities is roughly decreasing over life. We compute a measure of the importance of human capital for investment behavior. We find that ignoring labor income generates large utility costs, while the cost of ignoring only its risk is an order of magnitude smaller, except when we allow for a disastrous labor income shock. Moreover, we study the implications of introducing endogenous borrowing constraints in this incomplete-markets setting.

We use a unique database on ownership stakes of equity mutual fund directors to analyze whether the directors’ incentive structure is related to fund performance. Ownership of both independent and nonindependent directors plays an economically and statistically significant role. Funds in which directors have low ownership, or “skin in the game,” significantly underperform. We posit two economic mechanisms to explain this relation. First, lack of ownership could indicate a director’s lack of alignment with fund shareholder interests. Second, directors may have superior private information on future performance. We find evidence in support of the first and against the second mechanism.