Optimal Portfolio Choice Under Loss Aversion
31 Pages Posted: 29 Mar 2000 Last revised: 15 May 2018
Date Written: February 1, 2000
This paper analyses the optimal investment strategy for loss averse investors, assuming a complete market and general Ito processes for the asset prices. The loss averse investor follows a partial portfolio insurance strategy. When the planning horizon of the investor is short, i.e. less than 5 years, he or she considerably reduces the initial portfolio weight of stocks compared to an investor with smooth power utility. Consistent with popular investment advice, the initial portfolio weight of stocks of a loss averse investor typically increases with the investment horizon. The empirical section of the paper estimates the level of loss aversion implied by historical US stock market data, using a representative agent model. We find that loss aversion and risk aversion cannot be disentangled and provide a similar fit to the data.
JEL Classification: G11, G12
Suggested Citation: Suggested Citation