Household Portfolio Underdiversification and Probability Weighting: Evidence from the Field

Abstract

We test whether probability weighting affects household portfolio choice in a representative survey. On average, people display inverse-S shaped probability weighting, overweighting low probability events. As theory predicts, probability weighting is positively associated with portfolio underdiversification and significant Sharpe ratio losses. Analyzing respondents’ individual stock holdings, we find higher probability weighting is associated with owning lottery-type stocks and positively-skewed equity portfolios. People with higher probability weighting are less likely to own mutual funds and more likely to either avoid equities or hold individual stocks. We are the first to empirically link individuals’ elicited probability weighting and real-world decisions under risk.