Dynamic Portfolio Choice and Asset Pricing with Narrow Framing and Probability Weighting
64 Pages Posted: 3 Jun 2009 Last revised: 21 Jun 2012
Date Written: January 11, 2012
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.
Keywords: Narrow framing, cumulative prospect theory, probability weighting function, negative skewness, simulation methods
JEL Classification: D1, D8, G11, G12
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