The proliferation of novel preference theories in financial economics is hampered by a lack of non-experimental evidence and by the theories' additional complexity which has not been shown to be critical in applications. In this article I present arguments in support of preferences with rank dependency. Using the Survey of Consumer Finances data, I document two widespread patterns inconsistent with expected utility: (i) many households simultaneously invest in well-deversified funds and in poorly-diversified portfolios of stocks; and (ii) some households with substantial savings do not invest anything in equities. I show that portfolio choice models with rank-dependent preferences, plausibly parameterized and under fully rational assumptions, are quantitatively consistent with the observed diversification. These results call for further efforts to integrate the models of rank-dependent preferences in portfolio theory and asset pricing. Copyright 2005, Oxford University Press.

The proliferation of novel preference theories in financial economics is hampered by a lack of non-experimental evidence and by the theories' additional complexity which has not been shown to be critical in applications. In this article I present arguments in support of preferences with rank dependency. Using the Survey of Consumer Finances data, I document two widespread patterns inconsistent with expected utility: (i) many households simultaneously invest in well-deversified funds and in poorly-diversified portfolios of stocks; and (ii) some households with substantial savings do not invest anything in equities. I show that portfolio choice models with rank-dependent preferences, plausibly parameterized and under fully rational assumptions, are quantitatively consistent with the observed diversification. These results call for further efforts to integrate the models of rank-dependent preferences in portfolio theory and asset pricing.

[This article explores the implications of additive and endogenous habit formation preferences in the context of a life-cycle model of an investor who has stochastic uninsurable labor income. To solve the model, I analytically derive the habit-wealth feasibility constraints and show that they depend on the worst possible path of future labor income and on the habit strength, but not on the probability of the worst income. When there is only a slim chance of a severe income shock, the model implies much more conservative portfolios. The model also predicts that for some low to moderately wealthy households, the portfolio share allocated to stocks increases with wealth. Because of this feature, the model can generate more conservative portfolios for younger than for middle-aged households. The effects of habits on portfolio choice are robust to income smoothing through borrowing or flexible labor supply. One controversial finding is that for high values of the habit strength parameter, usually required for the resolution of asset pricing puzzles in general equilibrium, the life-cycle model predicts counterfactually high wealth accumulation.]

This article explores the implications of additive and endogenous habit formation preferences in the context of a life-cycle model of an investor who has stochastic uninsurable labor income. To solve the model, I analytically derive the habit-wealth feasibility constraints and show that they depend on the worst possible path of future labor income and on the habit strength, but not on the probability of the worst income. When there is only a slim chance of a severe income shock, the model implies much more conservative portfolios. The model also predicts that for some low to moderately wealthy households, the portfolio share allocated to stocks increases with wealth. Because of this feature, the model can generate more conservative portfolios for younger than for middle-aged households. The effects of habits on portfolio choice are robust to income smoothing through borrowing or flexible labor supply. One controversial finding is that for high values of the habit strength parameter, usually required for the resolution of asset pricing puzzles in general equilibrium, the life-cycle model predicts counterfactually high wealth accumulation. (JEL: G11, G12) Copyright 2007, Oxford University Press.

Abstract If an individual with expected utility and a reasonable level of wealth rejects a small actuarially favorable gamble, it implies a very high degree of risk aversion. It also predicts (counterfactually) the rejection of more sizable and very attractive bets. If additional background uncertainty affects wealth, this result also applies to non-expected utilities. The authors describe a set of reasonable conditions under which an individual may reject the small bet but accept the large bet, even in the presence of background uncertainty. The two critical assumptions that the authors use are rank-dependent utility and a discrete distribution for background risk. Plausible calibrations can reconcile large/small bet risk attitudes and the empirical evidence on limited stock market participation in the presence of labor income risk.

We examine a wide range of two-date economies populated by heterogeneous agents with the most common forms of nonexpected utility preferences used in finance and macroeconomics. We demonstrate that the risk premium and the risk-free rate in these models are sensitive to ignoring heterogeneity. This follows because of endogenous withdrawal by nonexpected utility agents from the market for the risky asset. This finding is important precisely because these alternative preferences have frequently been proposed as possible resolutions to various asset pricing puzzles, and they have all been examined exclusively in a representative agent framework.

ABSTRACT We examine a wide range of two‐date economies populated by heterogeneous agents with the most common forms of nonexpected utility preferences used in finance and macroeconomics. We demonstrate that the risk premium and the risk‐free rate in these models are sensitive to ignoring heterogeneity. This follows because of endogenous withdrawal by nonexpected utility agents from the market for the risky asset. This finding is important precisely because these alternative preferences have frequently been proposed as possible resolutions to various asset pricing puzzles, and they have all been examined exclusively in a representative agent framework.

[We study the simultaneous impact of fiscal policy decisions on macroeconomic activity, wealth distribution, and asset prices. We consider a general equilibrium, overlapping generations model with incomplete markets and heterogeneous agents, where government debt and capital are imperfect substitutes. Increases in public debt lead to significant increases in the riskless rate and to a reduction in the equity premium, while higher capital income tax rates lead to a higher equity premium. The crowding-out effects (on capital and output) are much higher than in models where government debt and capital are perfect substitutes, which thus ignore households' portfolio reallocation decisions.]

The empirical pricing kernels estimated from index options are non-monotone (Rosenberg and Engle, 2002, Bakshi et al., 2010) and the corresponding risk-aversion functions can be negative (Aït-Sahalia and Lo, 2000, Jackwerth, 2000). We show theoretically that these and several other properties of empirical pricing kernels are consistent with rank-dependent utility model with probability weighting function, which overweights tail events. We also estimate the pricing kernels nonparametrically from the Standard & Poor's 500 index options and construct empirical probability weighting functions. The estimated probability weights typically have the inverse-S shape, which overweights tail events and is widely supported by the experimental decision theory.

ABSTRACT Despite their mediocre mean performance, actively managed mutual funds are distinct from passive funds in their return distributions. Active value funds better hedge downside risk, while active growth funds better capture upside potential. Since such performance features may appeal to investors with tail‐overweighting preferences, we show that preferences for downside protection and upside potential estimated from the empirical pricing kernel can help explain active fund flows in the value and growth categories, respectively. This effect of investor risk preferences varies significantly with funds' downside‐hedging and upside‐capturing ability, with levels of active management, and across retirement and retail funds.