Stocks as Lotteries: The Implications of Probability Weighting for Security Prices

Nicholas Barberis and Ming Huang

No 12936, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be "overpriced," and can earn a negative average excess return. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.

JEL-codes: D1 D8 G11 G12 (search for similar items in EconPapers)
Date: 2007-02
New Economics Papers: this item is included in nep-fmk and nep-upt
Note: AP
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Citations: View citations in EconPapers (15)

Published as Barberis, Nicholas and Ming Huang. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices." American Economic Review 98, 5 (2008): 2006-2100.

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Journal Article: Stocks as Lotteries: The Implications of Probability Weighting for Security Prices (2008)
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