Guido Baltussen

Violations of Cumulative Prospect Theory in Mixed Gambles with Moderate Probabilities

In a classroom choice experiment with mixed gambles and moderate probabilities, we find severe violations of cumulative prospect theory (CPT) and of Markowitz stochastic dominance. Our results shed new light on the exchange between Levy and Levy (2002) and Wakker (2003) in this journal.

Unknown Unknowns: Uncertainty About Risk and Stock Returns

Stocks with high uncertainty about risk, as measured by the volatility of expected volatility (vol-of-vol), robustly underperform stocks with low uncertainty about risk by 8% per year. This vol-of-vol effect is distinct from (combinations of) at least 20 previously documented return predictors, survives many robustness checks, and holds in the United States and across European stock markets. We empirically explore the pricing mechanism behind the vol-of-vol effect. The evidence points toward preference-based explanations and away from alternative explanations. Collectively, our results show that uncertainty about risk is highly relevant for stock prices.

Risky Choice in the Limelight

This paper examines how risk behavior in the limelight differs from that in anonymity. In two separate experiments, we find that subjects are more risk averse in the limelight. However, risky choices are similarly path dependent in the different treatments. Under both limelight and anonymous laboratory conditions, a simple prospect theory model with a path-dependent reference point provides a better explanation for subjects’ behavior than a flexible specification of expected utility theory. In addition, our findings suggest that ambiguity aversion depends on being in the limelight, that passive experience has little effect on risk taking, and that reference points are determined by imperfectly updated expectations.

Risky Choice and the Relative Size of Stakes

We examine framing effects by analyzing how risky choice depends on the absolute and relative size of the amounts at stake, using an extensive sample of choices from ten different editions of the large-stake TV game show Deal or No Deal. Our analyses within and across the samples suggest that risky choice is highly sensitive to the context, as defined by the initial set of prizes in the game. In each sample, contestants respond in a similar way to the stakes relative to their initial level, even though the initial level differs widely across the various editions. Amounts therefore appear to be primarily evaluated relative to a subjective frame of reference rather than in terms of their absolute monetary value.

Exploiting Option Information in the Equity Market

Public option market information contains exploitable information for equity investors for an investable universe of liquid large-cap stocks. Strategies based on several option measures predict returns and alphas on the underlying stock. Transaction costs are an important factor given the high turnover of these strategies, but significant net alphas can be obtained when using a simple approach that reduces transaction costs. These findings suggest that information diffuses gradually from the option market into the underlying stock market. In our study, we examined whether public information contained in the option market predicts cross-sectional stock returns for a well-investable universe of highly liquid U.S. large-cap stocks and, thus, provides valuable, exploitable information for equity investors. We found that trading strategies based on worries about negative price movements (i.e., out-of-the-money volatility skew), volatility risk (i.e., realized versus implied volatility spread), informed trading and jump risk (i.e., at-the-money volatility skew), and the change in informed trading (i.e., the change in the at-the-money volatility skew) yield significant returns and alphas. The performances remain significant after correcting for market, size, value, momentum, reversal, and other return-predicting factors. Hence, we found that these strategies are substantially different from other well-known stock selection strategies. Further, a combined option information strategy shows even stronger results, with an annualized performance of around 10%, thereby strengthening the relevance of the publicly available information contained in option prices for equity investors. Although several studies have reported that the predictive power of option market variables decreases over time, we found significant returns also in recent out-of-sample years. These results are robust for bull, bear, volatile, and calm markets and are generally of similar magnitude for stocks with low or high information uncertainty. Exploiting the option information measures requires an extremely high turnover. Therefore, all profitability is estimated to be consumed by transaction costs in our investable universe. However, when we used our strategy on the largest 100 stocks—stocks that generally have the lowest transaction costs—and applied simple turnover-reducing portfolio construction rules, we found economically and statistically significant net returns above 7% a year for the long–short portfolio. This finding leads us to conclude that the documented strategies are exploitable by practitioners and suggests that information diffuses gradually from the equity option market into the underlying stock market.

Irrational Diversification: An Examination of the Portfolio Construction Decision

We study individual portfolio choice in a laboratory experiment and find strong evidence for heuristic behavior. The subjects tend to focus on the marginal distribution of an asset, while largely ignoring its diversification benefits. They follow a conditional 1/n diversification heuristic as they exclude the assets with an “unattractive” marginal distribution and divide the available funds equally between the remaining, “attractive” assets. This strategy is applied even if it leads to allocations that are dominated in terms of first-order stochastic dominance and is clearly irrational. In line with these findings, we find that framing and problem presentation have substantial influence on portfolio decisions.