Conventional economic models assume that investors confronted with risky choices maximize expected utility; yet in the real world, people are prone to making predictable errors.
Summary
Prior research has confirmed two anomalies in household portfolio choice: non-participation in the stock market and under-diversification among those who do participate. This study shows how a common behavioral bias known as probability weighting – i.e., overweighting small probabilities and underweighting large probabilities – influences household investment decisions. The results have important implications for how financial products are designed and communicated to savers and retirees.
Key Insights
- Probability weighting explains financial decisions that seemingly violate utility-maximizing behavior.
- Most people overweight small probabilities and underweight higher probabilities to some degree.
- Investors who overweight the probability of realizing extreme gains through equity exposure may prefer to hold a few individual stocks that could rise rapidly, versus investing in a broadly diversified portfolio.
- Risk-averse investors who underweight the likelihood of generating moderate positive returns through equity investments might prefer to avoid stocks altogether.
