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

50 Pages Posted: 24 Feb 2007 Last revised: 8 May 2022

See all articles by Nicholas Barberis

Nicholas Barberis

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

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.

Suggested Citation

Barberis, Nicholas and 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

Nicholas Barberis (Contact Author)

National Bureau of Economic Research (NBER)

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Ming Huang

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

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United States
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