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Dynamic portfolio choice and asset pricing with narrow framing and probability weighting

Author

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  • De Giorgi, Enrico G.
  • Legg, Shane

Abstract

This paper shows that the framework proposed by Barberis and Huang (2009) to incorporate narrow framing and loss aversion into dynamic models of portfolio choice and asset pricing can be extended to also account for probability weighting and for a value function that is convex on losses and concave on gains. We show that the addition of probability weighting and a convex–concave value function reinforces previous applications of narrow framing and cumulative prospect theory to understanding the stock market non-participation puzzle and the equity premium puzzle. Moreover, we show that a convex–concave value function generates new wealth effects that are consistent with empirical observations on stock market participation.

Suggested Citation

  • De Giorgi, Enrico G. & Legg, Shane, 2012. "Dynamic portfolio choice and asset pricing with narrow framing and probability weighting," Journal of Economic Dynamics and Control, Elsevier, vol. 36(7), pages 951-972.
  • Handle: RePEc:eee:dyncon:v:36:y:2012:i:7:p:951-972
    DOI: 10.1016/j.jedc.2012.01.010
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Nicholas C. Barberis, 2012. "Thirty Years of Prospect Theory in Economics: A Review and Assessment," NBER Working Papers 18621, National Bureau of Economic Research, Inc.
    2. repec:kap:theord:v:82:y:2017:i:4:d:10.1007_s11238-016-9582-8 is not listed on IDEAS
    3. Thomas Epper & Helga Fehr-Duda, 2012. "The missing link: Unifying risk taking and time discounting," ECON - Working Papers 096, Department of Economics - University of Zurich.
    4. Dorsaf Ben Aissia, 2016. "Developments in non-expected utility theories: an empirical study of risk aversion," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 40(2), pages 299-318, April.
    5. Jakub Steiner & Colin Stewart, 2016. "Perceiving Prospects Properly," American Economic Review, American Economic Association, vol. 106(7), pages 1601-1631, July.
    6. Nicholas C. Barberis, 2013. "Thirty Years of Prospect Theory in Economics: A Review and Assessment," Journal of Economic Perspectives, American Economic Association, vol. 27(1), pages 173-196, Winter.
    7. Guo, Jing & He, Xue Dong, 2017. "Equilibrium asset pricing with Epstein-Zin and loss-averse investors," Journal of Economic Dynamics and Control, Elsevier, vol. 76(C), pages 86-108.
    8. Epper, Thomas & Fehr-Duda, Helga, 2017. "A Tale of Two Tails: On the Coexistence of Overweighting and Underweighting of Rare Extreme Events," Economics Working Paper Series 1705, University of St. Gallen, School of Economics and Political Science.
    9. repec:eee:quaeco:v:66:y:2017:i:c:p:345-358 is not listed on IDEAS
    10. Steiner, Jakub & Stewart, Colin, 2014. "Perceiving Prospects Properly," 2007 Annual Meeting, July 29-August 1, 2007, Portland, Oregon TN 2015-39, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
    11. Shi, Yun & Cui, Xiangyu & Li, Duan, 2015. "Discrete-time behavioral portfolio selection under cumulative prospect theory," Journal of Economic Dynamics and Control, Elsevier, vol. 61(C), pages 283-302.

    More about this item

    Keywords

    Narrow framing; Cumulative prospect theory; Probability weighting function; Negative skewness; Dynamic programming;

    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; Trading Volume; Bond Interest Rates

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