Senior Fellows/Fellows
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Senior Fellows/Fellows
Household Portfolio Underdiversification and Probability Weighting: Evidence from the Field
We test the relation between probability weighting and household portfolio choice in a representative household survey, using custom-designed incentivized lotteries. On average, people display Inverse-S shaped probability weighting, overweighting the small probabilities of tail events. As theory predicts, our Inverse-S measure is positively associated with portfolio underdiversification, which results in significant Sharpe ratio losses. We analyze respondents’ individual stock holdings and find that people with higher Inverse-S tend to pick lottery-type stocks and hold positively-skewed equity portfolios. Furthermore, Inverse-S is positively associated with stock market nonparticipation. We find evidence indicating that these choices reflect preferences rather than probability unsophistication.
Keywords:
Household Finance, portfolio underdiversification, probability weighting, rank dependent utility, cumulative prospect theory, salience theory, household portfolio puzzles, stock market participation