Wharton Pension Research Council Working Papers
 

Document Type

Working Paper

Date of this Version

12-18-2018

Abstract

We test the relation between probability weighting and household portfolio choice in a representative household survey, using custom-designed incentivized lotteries. On average, people display Inverse-S shaped probability weighting, overweighting the small probabilities of tail events. As theory predicts, our Inverse-S measure is positively associated with portfolio underdiversification, which results in significant Sharpe ratio losses. We analyze respondents’ individual stock holdings and find that people with higher Inverse-S tend to pick lottery-type stocks and hold positively-skewed equity portfolios. Furthermore, Inverse-S is positively associated with stock market nonparticipation. We find evidence indicating that these choices reflect preferences rather than probability unsophistication.

Comments

This paper is part of the NBER’s Research Program on the Economics of Aging and the Working Group on Household Portfolios. This project received funding from the TIAA Institute and Wharton School’s Pension Research Council/Boettner Center

Keywords

household finance, portfolio underdiversification, probability weighting, rank dependent utility, cumulative prospect theory, salience theory, household portfolio puzzles, stock market participation

JEL Code

G11, D81, D14, C83

Working Paper Number

WP-2018-09

Copyright/Permission Statement

The content is solely the responsibility of the authors and does not represent official views of the TIAA Institute or the Wharton School’s Pension Research Council/Boettner Center. © 2018 Dimmock, Kouwenberg, Mitchell, and Peijnenburg.

Acknowledgements

For assistance with the survey, the authors gratefully acknowledge Tim Colvin, David Grant, and the American Life Panel team at the RAND Corporation. For comments, we thank Jose Miguel Abito, John Campbell, Nicola Gennaioli, Nishad Kapadia, Alexander Klos, Sonya Lim, Gianpaolo Parise, Valery Polkovnichenko, Meir Statman, Peter Wakker, and Joe Zhang; seminar participants at EDHEC, ESSEC, HEC Paris, IESE Business School, London School of Economics, University of Cambridge, and University of Warwick; and participants at the Financial Intermediation Research Society, SFS Cavalcade, Singapore Symposium, TIAA/PRC Symposium, and Western Finance Association. Yunju Cha and Yong Yu provided outstanding research assistance.

Additional Files

Online_Appendix_2018-08-08.pdf (872 kB)

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Economics Commons

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Date Posted: 06 February 2019