Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing

Abstract:     
We argue that "narrow framing," whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making than previously realized. Our starting point is the evidence that people are often averse to a small, independent gamble, even when the gamble is actuarially favorable. We find that a surprisingly wide range of utility functions, including many non-expected utility specifications, have trouble explaining this evidence; but that this difficulty can be overcome by allowing for narrow framing. Our analysis makes predictions as to what kinds of preferences can most easily address the stock market participation puzzle, as well as other related financial puzzles. We confirm these predictions in a simple portfolio choice setting.

Number of Pages in PDF File: 33

Keywords: risk aversion, framing, loss aversion, stock market participation

JEL Classification: D1, D8, G11, G12

Accepted Paper Series