50 Pages Posted: 24 Feb 2007
Date Written: February 2007
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.
Suggested Citation: Suggested Citation
Barberis, Nicholas and Huang, Ming, Stocks as Lotteries: The Implications of Probability Weighting for Security Prices (February 2007). NBER Working Paper No. w12936. Available at SSRN: https://ssrn.com/abstract=965128