Rank-Dependent Utility and Risk Taking in Complete Markets
40 Pages Posted: 27 Jan 2015 Last revised: 25 Jun 2016
Date Written: April 19, 2016
Experimental studies show that people's risk preferences depend non-linearly on probabilities, but relatively little is known about how probability weighting influences investment decisions. In this paper we analyze the portfolio choice problem of investors who maximize rank-dependent utility in a single-period complete market. We prove that investors with a less risk averse preference relation in general choose a more risky final wealth distribution, receiving a risk premium in return for accepting conditional-zero-mean noise (more risk). We also propose a new scenario-based notion of less risk taking that can be applied when state probabilities are unknown.
Keywords: rank-dependent utility; portfolio selection; risk aversion; complete markets; less risky terminal wealth; optimal stock holding
JEL Classification: G11
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