Working Paper: NBER ID: w24928
Authors: Stephen G. 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 portfolios; probability weighting; underdiversification; financial literacy; psychological biases
JEL Codes: C83; D14; D81; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| probability weighting (inverses) (C46) | fraction of equity allocated to individual stocks (G12) |
| probability weighting (inverses) (C46) | mutual fund ownership (G23) |
| probability weighting (inverses) (C46) | Sharpe ratio (G11) |
| probability weighting (inverses) (C46) | skewness-seeking behavior (D91) |
| probability weighting (inverses) (C46) | underdiversification (D80) |