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

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.