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

  • De Giorgi, Enrico G.
  • Legg, Shane

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.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 36 (2012)
Issue (Month): 7 ()
Pages: 951-972

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Handle: RePEc:eee:dyncon:v:36:y:2012:i:7:p:951-972
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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  1. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 63-91, March.
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  5. Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
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  7. David K. Backus & Bryan R. Routledge & Stanley E. Zin, 2005. "Exotic Preferences for Macroeconomists," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 319-414 National Bureau of Economic Research, Inc.
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  9. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
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  18. Bryan R. Routledge & Stanley E. Zin, 2003. "Generalized Disappointment Aversion and Asset Prices," NBER Working Papers 10107, National Bureau of Economic Research, Inc.
  19. Enrico Giorgi & Thorsten Hens & János Mayer, 2007. "Computational aspects of prospect theory with asset pricing applications," Computational Economics, Society for Computational Economics, vol. 29(3), pages 267-281, May.
  20. Barberis, Nicholas & Huang, Ming, 2009. "Preferences with frames: A new utility specification that allows for the framing of risks," Journal of Economic Dynamics and Control, Elsevier, vol. 33(8), pages 1555-1576, August.
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  22. Enrico De Giorgi & Thorsten Hens & Marc Oliver Rieger, 2007. "Financial Market Equilibria With Cumulative Prospect Therory," Swiss Finance Institute Research Paper Series 07-21, Swiss Finance Institute, revised Aug 2007.
  23. Harrison Hong & Jeffrey D. Kubik & Jeremy C. Stein, 2004. "Social Interaction and Stock-Market Participation," Journal of Finance, American Finance Association, vol. 59(1), pages 137-163, 02.
  24. Nicholas Barberis & Ming Huang & Richard H. Thaler, 2006. "Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing," American Economic Review, American Economic Association, vol. 96(4), pages 1069-1090, September.
  25. Haim Levy, 2004. "Prospect Theory and Mean-Variance Analysis," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 1015-1041.
  26. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  27. Yaari, Menahem E, 1987. "The Dual Theory of Choice under Risk," Econometrica, Econometric Society, vol. 55(1), pages 95-115, January.
  28. Xue Dong He & Xun Yu Zhou, 2011. "Portfolio Choice Under Cumulative Prospect Theory: An Analytical Treatment," Management Science, INFORMS, vol. 57(2), pages 315-331, February.
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