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Dynamic Portfolio Choice and Asset Pricing with Narrow Framing and Probability Weighting

Enrico De Giorgi & Shane Legg

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abstract This paper shows that the framework proposed by Barberis and Huang (2009) to incorporate narrow framing and loss aversion in dynamic models of portfolio choice and asset pricing can be extended to also account for probability weighting and a value function which is convex on losses and concave on gains. We show that the addition of probability weighting and a convex-concave value function reinforces previous applications of narrow framing and cumulative prospect theory to explain the stock market non-participation puzzle and the equity premium puzzle. Moreover, we show that a convex-concave value function generates new wealth effects that are consistent with empirical observations on stock market participation.
   
type journal paper
   
keywords Narrow framing, cumulative prospect theory, negative skewness, simulation methods.
   
project Applying Recent Developments in Computational Statistics to Behavioral Asset Pricing and Portfolio Selection
language English
kind of paper journal article
date of appearance 7-2012
journal Journal of Economic Dynamics and Control
publisher Elsevier (Amsterdam)
ISSN 0165-1889
ISSN (online) 1879-1743
DOI 10.1016/j.jedc.2012.01.010
volume of journal 36
number of issue 7
page(s) 951-972
review double-blind review
   
citation De Giorgi, E., & Legg, S. (2012). Dynamic Portfolio Choice and Asset Pricing with Narrow Framing and Probability Weighting. Journal of Economic Dynamics and Control, 36(7), 951-972, DOI:10.1016/j.jedc.2012.01.010.