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Heterogeneity of probability weighting in investment decisions

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  • Sun, Yuzhe
  • Zhang, Shunming

Abstract

This study examines how the heterogeneity of elevation or curvature in probability weighting affects investors’ market participation and the equity premium. We analyze the rank-dependent utility with the generalized Wang transform (GWT) as an inverse S-shaped weighting function. The two parameters of GWT elicit pessimism (elevation) and likelihood insensitivity to less extreme probability (curvature). There is non-participation when the heterogeneity of elevation or curvature is significant. The mean of elevation does not affect market participation, but that of curvature does. With elevation dispersion, a GWT weighting function with a single prior is compatible with a maxmin model with multiple priors.

Suggested Citation

  • Sun, Yuzhe & Zhang, Shunming, 2023. "Heterogeneity of probability weighting in investment decisions," Economics Letters, Elsevier, vol. 228(C).
    • Handle: RePEc:eee:ecolet:v:228:y:2023:i:c:s0165176523001817
    DOI: 10.1016/j.econlet.2023.111156
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    References listed on IDEAS

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    More about this item

    Keywords

    Elevation; Curvature; Generalized Wang transform; Market participation; Rank-dependent utility;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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