Dynamic Portfolio Choice and Asset Pricing with Narrow Framing and Probability Weighting

Enrico G. de Giorgi and Shane Legg
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Enrico G. de Giorgi: University of St. Gallen, Swiss Finance Institute and University of Lugano
Shane Legg: University College London and University of Lugano

No 09-25, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: This paper extends the model with narrow framing suggested by Barberis and Huang (2009) to also account for probability weighting and a convex-concave value function in the specification of cumulative prospect theory preferences on narrowly framed assets. We show that probability weighting is needed in order that investors reduce their holding of narrowly framed risky assets in the presence of negative skewness and high Sharpe ratios, which are typ- ical characteristics of stock index returns. The model with framing and probability weighting can thus explain the stock participation puzzle under realistic assumptions on stock market returns. We also show that a convex-concave value function generates wealth effects that are consistent with empirical observations on stock market participation. Finally, we address the asset pricing implications of probability weighting in the model with narrow framing and show that in the case of negative skewness the equity premium of narrowly framed assets is much higher than when probability weighting is not taken into account.

Keywords: Narrow framing; cumulative prospect theory; probability weighting function; negative skewness; simulation methods (search for similar items in EconPapers)
JEL-codes: D1 D8 G11 G12 (search for similar items in EconPapers)
Pages: 52 pages
Date: 2009-06
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp0925

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