Inverse S-Shaped Probability Weighting and Its Impact on Investment

43 Pages Posted: 10 Nov 2017

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

The Chinese University of Hong Kong (CUHK) - Department of Systems Engineering & Engineering Management

Date Written: November 7, 2017

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

Suggested Citation

He, Xue Dong and Kouwenberg, Roy R. P. and Zhou, Xun Yu, Inverse S-Shaped Probability Weighting and Its Impact on Investment (November 7, 2017). Available at SSRN: https://ssrn.com/abstract=3067189 or http://dx.doi.org/10.2139/ssrn.3067189

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

Xun Yu Zhou

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

Shatin, New Territories
Hong Kong
852 2609-8320 (Phone)
852 2603-5505 (Fax)

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