Individual Preferences, Monetary Gambles and the Equity Premium
We argue that narrow framing, whereby an agent who is offered a new gamble evaluates that gamble in isolation, separately from other risks she already faces, may be a more important feature of decision-making under risk than previously realized. To demonstrate this, we present evidence on typical attitudes to independent monetary gambles with both large and small stakes and show that across a wide range of utility functions, including all expected utility and many non-expected utility specifications, the only ones that can easily capture these attitudes are precisely those exhibiting narrow framing. Our analysis also makes predictions about the kinds of preferences that might be able to address the stock market participation and equity premium puzzles. We illustrate these predictions in simple portfolio choice and equilibrium settings.
Published: Barberis, N., Huang, M. and R. Thaler. “Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing.” American Economic Review 96 (2006): 1069-1090.