Rank-Dependent Utility and Risk Taking in Complete Markets

40 Pages Posted: 27 Jan 2015 Last revised: 25 Jun 2016

See all articles by Xue Dong He

Xue Dong He

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management

Roy Kouwenberg

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Mahidol University - College of Management

Xun Yu Zhou

Columbia University - Department of Industrial Engineering and Operations Research (IEOR)

Date Written: April 19, 2016

Abstract

Experimental studies show that people's risk preferences depend non-linearly on probabilities, but relatively little is known about how probability weighting influences investment decisions. In this paper we analyze the portfolio choice problem of investors who maximize rank-dependent utility in a single-period complete market. We prove that investors with a less risk averse preference relation in general choose a more risky final wealth distribution, receiving a risk premium in return for accepting conditional-zero-mean noise (more risk). We also propose a new scenario-based notion of less risk taking that can be applied when state probabilities are unknown.

Keywords: rank-dependent utility; portfolio selection; risk aversion; complete markets; less risky terminal wealth; optimal stock holding

JEL Classification: G11

Suggested Citation

He, Xue Dong and Kouwenberg, Roy R. P. and Zhou, Xunyu, Rank-Dependent Utility and Risk Taking in Complete Markets (April 19, 2016). Available at SSRN: https://ssrn.com/abstract=2555244 or http://dx.doi.org/10.2139/ssrn.2555244

Xue Dong He (Contact Author)

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management ( email )

505 William M.W. Mong Engineering Building
The Chinese University of Hong Kong, Shatin, N.T.
Hong Kong
Hong Kong

HOME PAGE: http://https://sites.google.com/site/xuedonghepage/home

Roy R. P. Kouwenberg

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

HOME PAGE: http://people.few.eur.nl/kouwenberg

Mahidol University - College of Management ( email )

69 Vipawadee Rangsit Road
Bangkok, 10400
Thailand

HOME PAGE: http://www.cmmu.mahidol.ac.th/main/faculty/aroy.asp

Xunyu Zhou

Columbia University - Department of Industrial Engineering and Operations Research (IEOR) ( email )

331 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

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