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Household Portfolio Underdiversification and Probability Weighting: Evidence from the Field

Stephen G. Dimmock, Roy Kouwenberg, Olivia S. Mitchell, Kim Peijnenburg

NBER Working Paper No. 24928
Issued in August 2018
NBER Program(s):Aging, Public Economics

We explore the relation between probability weighting and household portfolio underdiversification in a representative household survey, using custom-designed incentivized lotteries. On average, people display Inverse-S shaped probability weighting, overweighting the small probabilities of tail events. As theory predicts, our Inverse-S measure is positively associated with portfolio underdiversification, which results in significant Sharpe ratio losses. We match respondents’ individual stock holdings to CRSP data and find that people with higher Inverse-S tend to pick stocks with positive skewness and hold positively-skewed equity portfolios. We show that these choices reflect preferences rather than probability unsophistication or limited financial knowledge.

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Document Object Identifier (DOI): 10.3386/w24928

 
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