DP13109 Household Portfolio Underdiversification and Probability Weighting: Evidence from the Field

Author(s): Steve Dimmock, Roy Kouwenberg, Olivia S Mitchell, Kim Peijnenburg
Publication Date: August 2018
Keyword(s): cumulative prospect theory, household finance, household portfolio puzzles, portfolio underdiversification, probability weighting, rank dependent utility, Stock Market Participation
JEL(s): C83, D14, D81, G11
Programme Areas: Financial Economics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=13109

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.