Diversification in Lottery-Like Features and Portfolio Pricing Discounts
72 Pages Posted: 25 Aug 2017 Last revised: 10 Sep 2018
Date Written: September 10, 2018
Why is a portfolio sometimes valued less than the sum of its underlying components? In this paper, I provide a novel explanation for the question by utilizing mergers and acquisitions, closed-end funds and conglomerates, where the value of the aggregate portfolio and the values of the underlying components can be separately evaluated. I extend the model of Barberis and Huang (2008) and show that, a portfolio is traded at a discount when its underlying assets exhibit strong lottery-like features but a low tendency to produce extreme payoffs at the same time. I present evidence supporting this model implication and provide a novel and unifying explanation for the announcement-day returns of mergers and acquisitions, the closed-end fund discount puzzle, and the conglomerate discount.
Keywords: Cumulative Prospect Theory, Diversification, Lottery-like Feature, CoMax, Discount
JEL Classification: G11, G12, G41
Suggested Citation: Suggested Citation