The participation puzzle with reference-dependent expected utility preferences
Liqun Liu and
William Neilson ()
Insurance: Mathematics and Economics, 2020, vol. 93, issue C, 278-287
Expected utility theory with a smooth utility function predicts that, when allocating wealth between a risky and a riskless asset, investors allocate a positive amount to the risky asset whenever its expected return exceeds the riskless rate of return. A large number of people invest none of their wealth in risky assets, though, leading to the ”participation puzzle.” This paper explores whether the participation puzzle can be addressed when the utility function has a kink at the reference wealth level. It shows that when the reference wealth level is initial wealth increased by the riskless rate of return, there exists a range of expected excess returns for the risky asset for which the investor takes no position. Moreover, this range of expected excess returns is described by comparing a common performance measure of stock returns, the Omega Function, to a function of preference parameters. However, if the reference wealth level is any other constant, the usual expected utility prediction holds and investors allocate at least some of their wealth to the risky asset whenever it has a positive expected excess return.
Keywords: Portfolio choice; Behavioral decision making; Reference point; Loss aversion; Participation puzzle (search for similar items in EconPapers)
JEL-codes: D81 G11 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:insuma:v:93:y:2020:i:c:p:278-287
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