Dynamic Portfolio Selection and Asset Pricing Under Neo-Additive Probability Weighting

We study a dynamic portfolio selection problem in which an agent trades a stock and a risk-free asset with the objective of maximizing the rank-dependent utility of their wealth at the terminal time of the investment horizon. Because of time inconsistency, we consider three types of agents, namely precommitted, sophisticated, and naive agents, who differ from each other in whether they are aware of the time inconsistency and whether they have self-control. Assuming a neo-additive probability weighting function, we solve the strategies of these agents. We find that the precommitted agent takes a loss-exit strategy, leading to a positively skewed terminal wealth, and that the sophisticated agent is less willing to participate in the stock market than the precommitted and naive agents. We also study equilibrium asset pricing and find that with a precommitted representative agent, stock returns exhibit a reversal effect, and the initial stock price is lower than in the case of a naive representative agent or a sophisticated representative agent.

This paper was accepted by Manel Baucells, behavioral economics and decision analysis.

Funding: This work was supported by Research Grants Council, University Grants Committee [Grant GRF 14218022]. Y. Sun acknowledges financial support from a start-up fund at Peking University HSBC Business School.

Supplemental Material: The online appendices and data files are available at https://doi.org/10.1287/mnsc.2023.03551.