Working Paper: CEPR ID: DP13109
Authors: Steve Dimmock; Roy Kouwenberg; Olivia S. Mitchell; Kim Peijnenburg
Abstract: We explore the relation between probability weighting and household portfolio underdiversification 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 match respondents’ individual stock holdings to CRSP data and find that people with higher Inverse-S tend to pick stocks with positive skewness and hold positively-skewed equity portfolios. We show that these choices reflect preferences rather than probability unsophistication or limited financial knowledge.
Keywords: household finance; portfolio underdiversification; probability weighting; rank dependent utility; cumulative prospect theory; household portfolio puzzles; stock market participation
JEL Codes: G11; D81; D14; C83
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| larger fraction of portfolio allocated to individual stocks (G11) | underdiversification (D80) |
| higher inverses (C36) | underdiversification (D80) |
| higher inverses (C36) | lower Sharpe ratio (G19) |
| lower Sharpe ratio (G19) | lower expected returns (G12) |
| higher inverses (C36) | larger fraction of portfolio allocated to individual stocks (G11) |