Skewness, idiosyncratic volatility and probability weighting – how can wealth managers help clients?

Abstract

Probability weighting, the overweighting of small probabilities and underweighting of large probabilities in a nonlinear way, describes well how most individuals form decisions under risk. Probability weighting has implications to preferences in investment, in particular the preference for assets with skewed returns. The purpose of this thesis is to derive the extent of probability weighting, explore how probability weighting influences preferences, and explore related concepts through an experiment. We will then use the results from the experiment to discuss how to incorporate probability weighting into the wealth management process. We find that probability weighting is an important characteristic to describe people preferences; in particular, we find that about half the respondents are willing to sacrifice higher expected return and lower variance to obtain more skewed payoffs. There are large preference reversals that cannot be explained by expected utility. Apart from the collection of data, we contribute to the behavioural finance literature with analysis of the findings and development of advices. We emphasise the use of diagnostic tools and discuss whether portfolios need products to enhance skewness.