NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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

Nicholas Barberis, Ming Huang

NBER Working Paper No. 12936
Issued in February 2007
NBER Program(s):   AP

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.

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Document Object Identifier (DOI): 10.3386/w12936

Published: Barberis, Nicholas and Ming Huang. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices." American Economic Review 98, 5 (2008): 2006-2100.

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