Probability distortion and non-participation

Abstract

This paper explores the impact of probability distortion on investors’ participation decisions and market performance. Specifically, we construct a one-period investment model with two types of investors—probabilistic pessimistic and neutral investors. The former assign more weight to bad outcomes and tail events when making decisions. Our findings suggest that non-participation arises from these probabilistic pessimistic investors. In equilibrium, their participation decisions affect the asset premium, which can be decomposed into the risk premium and probabilistic premium.