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Stocks as Lotteries: the Implications of Probability Weighting for Security Prices

49 Pages Posted: 16 Jan 2005  

Nicholas Barberis

Yale School of Management; National Bureau of Economic Research (NBER)

Ming Huang

Cornell University - Samuel Curtis Johnson Graduate School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: February 2007

Abstract

We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be overpriced, and can earn a negative average excess return. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.

Keywords: prospect theory, asset pricing, skewness, under-diversification

JEL Classification: D1, D8, G11, G12

Suggested Citation

Barberis, Nicholas and Huang, Ming, Stocks as Lotteries: the Implications of Probability Weighting for Security Prices (February 2007). AFA 2005 Philadelphia Meetings Paper. Available at SSRN: https://ssrn.com/abstract=649421 or http://dx.doi.org/10.2139/ssrn.649421

Nicholas Barberis (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-436-0777 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ming Huang

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States
607-225-9594 (Phone)

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