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

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...

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Bibliographic Details
Published in:	Journal of economic dynamics & control 2012-07, Vol.36 (7), p.951-972
Main Authors:	De Giorgi, Enrico G., Legg, Shane
Format:	Article
Language:	eng
Subjects:	Asset pricing Cumulative prospect theory Decision making models Dynamic models Dynamic programming Equity Market prices Mathematical analysis Narrow framing Negative skewness Portfolio analysis Probability Probability weighting Probability weighting function Securities markets Stock exchange Studies Value theory
Online Access:	Get full text
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Summary:	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.
ISSN:	0165-1889 1879-1743