Stocks as Lotteries: the Implications of Probability Weighting for Security Prices

By Nicholas Barberis, Ming Huang. 2008

1,448 citations recorded by the source corpus.

We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be "overpriced," and can earn a negative average excess return. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.

Subfields: Accounting, Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/5fec1cda9869d91a1935efa317fe222c646b81b2

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Citations in the corpus

Charles A. Dice Center for Research in Financial Economics The Implied Cost of Capital: A New Approach (2010, neutral): “Barberis and Huang (2008) argue that under cumulative prospect theory, investors overweigh small chances of large gains (hence the lottery preferences).”
Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility around the World (2015, neutral): “…controls span contemporaneous world market index factor or Fama–French (1993) risk factors, 1-month lagged returns (Huang et al. (2009)), and 6-month momentum returns (Jegadeesh and Titman (1993)), book-to-market (Daniel and Titman (1997)), skewness (Barberis and Huang (2008)), and firm size.”
Keynes Meets Markowitz: The Tradeoff Between Familiarity and Diversification (2009, neutral): “…investors’ preference for skewness (Kraus and Litzenberger, 1976; Conine and Tamarkin, 1981; Harvey and Siddique, 2000; Mitton and Vorkink, 2007; Barberis and Huang, 2008), employees’ loyalty toward the company where they work (Cohen, 2009), rank-dependent preferences (Polkovnichenko, 2005),…”
Do Individual Investors Have Asymmetric Information Based on Work Experience (2011, neutral): “Barberis and Huang (2008) and Kumar (2009) discuss this.”
High idiosyncratic volatility and low returns: International and further U.S. evidence (2008, neutral): “If high idiosyncratic volatility stocks are stocks with positive skewness, the Barberis and Huang (2005) argument would explain why stocks with high idiosyncratic volatility have low returns.”
Stock Options as Lotteries (2014, neutral): “, Brunnermeier and Parker (2005), Barberis and Huang (2007), and Mitton, and Vorkink (2006)).”
Psychology-based Models of Asset Prices and Trading Volume (2018, methodology): “Barberis and Huang (2008) assume instead that investors evaluate risk according to cumulative prospect theory: for each possible portfolio strategy, they use equations (22)-(25) to compute the prospect theory value of the distribution of gains and losses that would result from that portfolio…”
The Limits of the Limits of Arbitrage (2010, background): “…copy available at: https://ssrn.com/abstract=3816013 stocks, recent losers, and negative earnings surprises earn returns that are lower than predicted (see, e.g., Ritter, 1991; Barberis and Huang, 2008; Ball and Brown, 1968; Bernard and Thomas, 1990; Chan et al., 1996).”
Do extreme returns matter in emerging markets? Evidence from the Chinese stock market (2017, neutral): “like (positively skewed) wealth distributions (Barberis and Huang, 2008).”
Expected Idiosyncratic Skewness (2010, neutral): “Barberis and Huang (2007) show that when securities have return distributions that are”
The Skewness of Commodity Futures Returns (2018, neutral): “While theory predicts a negative relation between skewness and expected returns (Mitton and Vorkink, 2007; and Barberis and Huang, 2008), empirical results are mixed ( e.g., Kumar (2009), Bali et al. (2011), Amaya et al. (2015) find evidence in support of this negative relation, whereas Xiang et…”