Inverse S-Shaped Probability Weighting and Its Impact on Investment

Abstract

In this paper we analyze how changes in inverse S-shaped probability weighting influence optimal portfolio choice in a rank-dependent utility model. We derive sufficient conditions for the existence of an optimal solution of the investment problem, and then define the notion of a more inverse S-shaped probability weighting function. We show that an increase in inverse S-shaped weighting typically leads to a lower allocation to the risky asset, regardless of whether the return distribution is skewed left or right, as long as it offers a non-negligible risk premium. Only for lottery stocks with poor expected returns and extremely positive skewness does an increase in inverse S-shaped probability weighting lead to larger portfolio allocations.

Keywords: Rank-Dependent Utility; Portfolio Selection; Probability Weighting; Inverse S-shaped Weighting Function; Optimal Stock Holding

JEL Classification: G11