Heterogeneity of Probability Weighting in Investment Decisions

This study examines the ways in which the heterogeneity of elevation or curvature in probability weighting affects investors’ market participation and the equity premium. We analyze the rank-dependence utility with the generalized Wang transform (GWT) as an inverse S-shaped weighting function. The two parameters of GWT elicit pessimism (elevation) and likelihood insensitivity to less extreme probability (curvature). There is non-participation when the heterogeneity of elevation or curvature is significant. The mean of elevation does not affect market participation but that of curvature does. With elevation dispersion, a GWT weighting function with a single prior is compatible with a maxmin model with multiple priors