Household Wealth and Portfolio Choice When Tail Events Are Salient

Robust experimental evidence of violations of expected utility (EU) establishes that individuals overweight utility from low probability gains and losses. These findings motivated development of rank dependent utility (RDU). We provide novel solutions for optimal portfolios of such investors facing dynamic, binomial returns. Our calibrated model shows optimal terminal wealth has significant downside protection, upside exposure, and a lottery component. We calculate that RDU investors would pay 5% of their initial wealth to trade away from an optimal EU wealth allocation. The optimal dynamic trading strategy requires higher risky share after good returns and, possibly, nonparticipation when returns are poor.