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

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Author Info
Nicholas Barberis
Ming Huang
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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12936.

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Date of creation: Feb 2007
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Handle: RePEc:nbr:nberwo:12936

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Find related papers by JEL classification:
D1 - Microeconomics - - Household Behavior
D8 - Microeconomics - - Information, Knowledge, and Uncertainty
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  2. Brunnermeier, Markus & Gollier, Christian & Parker, Jonathan, 2007. "Optimal Beliefs, Asset Prices, and the Preference for Skewed Returns," IDEI Working Papers 429, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
    Other versions:
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    Other versions:
  9. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory And Asset Prices," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 1-53, February. [Downloadable!] (restricted)
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    Other versions:
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  15. Paul Schultz, 2003. "Pseudo Market Timing and the Long-Run Underperformance of IPOs," Journal of Finance, American Finance Association, vol. 58(2), pages 483-518, 04. [Downloadable!] (restricted)
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