The Role of Learning in Dynamic Portfolio Decisions

This paper analyzes the effect of uncertainty about the meanreturn on the risky asset on the portfolio decisions of an investorwho has a long investment horizon. Building on the earlier workof Detemple (1986), Dothan and Feldman (1986), and Gennotte(1986), it is shown that the possibility of future learningabout the mean return on the risky asset induces the investorto take a larger or smaller position in the risky asset thanshe would if there were no learning, the direction of the effectdepending on whether the investor is more or less risk tolerantthan the logarithmic investor whose portfolio decisions areunaffected by the possibility of future learning. Numericalcalculations show that uncertainty about the mean return onthe market portfolio has a significant effect on the portfoliodecision of an investor with a 20 year horizon if her assessmentof the market risk premium is based solely on the Ibbotson andSinquefield (1995) data.