Optimal consumption and portfolio choice with loss aversion

  • his paper analyses the consumption-investment problem of a loss averse investor equipped with s-shaped utility over consumption relative to a time-varying reference level. Optimal consumption exceeds the reference level in good times and descend to the subsistence level in bad times. Accordingly, the optimal portfolio is dominated by a mean-variance component in good times and rebalanced more aggressively toward stocks in bad times. This consumption-investment strategy contrasts with customary portfolio theory and is consistent with several recent stylized facts about investors' behaviour. I also analyse the joint effect of loss aversion and persistence of the reference level on optimal choices. Finally, the strategy of the loss averse investor outperforms the conventional Merton-style strategies in bad times, but tend to be dominated by the conventional strategies in good times.

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Author:Giuliano Curatola
Parent Title (English):SAFE working paper series ; No. 130
Series (Serial Number):SAFE working paper (130)
Place of publication:Frankfurt am Main
Document Type:Working Paper
Year of Completion:2016
Year of first Publication:2016
Publishing Institution:Universit├Ątsbibliothek Johann Christian Senckenberg
Release Date:2016/04/12
Tag:Consumption-portfolio choice; Habit-formation; Loss-aversion
Page Number:40
Institutes:Wirtschaftswissenschaften / Wirtschaftswissenschaften
Wissenschaftliche Zentren und koordinierte Programme / House of Finance (HoF)
Wissenschaftliche Zentren und koordinierte Programme / Center for Financial Studies (CFS)
Wissenschaftliche Zentren und koordinierte Programme / Sustainable Architecture for Finance in Europe (SAFE)
Dewey Decimal Classification:3 Sozialwissenschaften / 33 Wirtschaft / 330 Wirtschaft
Licence (German):License LogoDeutsches Urheberrecht