Abstract

Can Prospect Theory explain it? Home bias phenomena and the notion of risk

Livio Stracca

European Central Bank

This paper attempts to provide an explanation to the ''home bias puzzle'' in portfolio allocation and consumption choice, using a non-standard specification of agents' preferences, which draws from recent experimental evidence, and in particular from Prospect Theory as in Kahneman and Tversky (1979) and Tversky and Kahneman (1991). It argues that with a specification of preferences in which the mere appearance of a shock matters, in addition to, or even instead of, the size of the shock itself, risk sharing may be useless and even counterproductive. This may in turn help explain why in many important settings risk diversification may not be a ''natural'' inclination of human behaviour, enshrined in preferences. Moreover, the paper argues that the presence of ''reference values'' and of incomplete and asymmetric information may support such specification. This seems particularly appropriate to study consumption and investment decisions, and hence explain the emergence of (rational) home bias phenomena for these.