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UBC Theses and Dissertations

Essays on the rank-wealth hypothesis Newton, David

Abstract

This thesis comprises two manuscripts which sequentially develop and test the Rank-Wealth Model (RWM). The first manuscript constructs the RWM from basic economic principles by assuming consumer good indivisibility. If consumer goods are indivisible, and one also assumes finite supply and homogeneous preferences, the resultant derived utility function of each individual will become their rank in society. This is an important result for it can explain 'Keeping up with the Joneses' motives as well as generate a value function that in the aggregate closely resembles Kahneman and Tversky's Prospect Theory (1979). The RWM can therefore explain a number of nancial anomalies including the endowment effect, simultaneous gambling and insuring, lottery regressivity and sub-optimal diversification. The second manuscript tests some of the predictions that arise from RWM. Using methodology similar to Kumar (2009) the second study begins by confirming the previously documented observation that poor individuals hold more lottery-type-stocks (LTS) than the rich. Next, tests of the RWM are conducted using a proxy variable that measures individual rank as well as the Gini measure of wealth concentration. As expected, high LTS portfolios do underperform low LTS portfolios using standard risk metrics but that dominance is reversed when rank is considered. The second manuscript provides empirical support for the RWM by showing that it may be fully rational for the poorest individuals to concentrate their portfolio value into a few stocks that have higher idiosyncratic risk and skewness even if the (conventional) risk-adjusted expected return of those stocks is negative.

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