Loss Aversion, Survival and Asset Prices

Abstract:     
This paper studies the wealth and pricing implications of loss aversion in the presence of arbitrageurs with Epstein-Zin preferences. Our analysis shows that if loss aversion is the only difference in investors' preferences, then for empirically relevant parameter values, loss-averse investors will be driven out of the market and thus they do not affect long-run prices. The market selection process is slow in terms of wealth shares; but, because of endogenous withdrawal by loss-averse investors from the stock market, it is fast in terms of price impact. We also find that saving behavior is critical in determining survival prospects.

Number of Pages in PDF File: 50

Keywords: loss aversion, Epstein-Zin preferences, market selection, asset pricing

JEL Classification: G11, G12, D50

working papers series