Optimal Consumption and Portfolio Choice with Loss Aversion
38 Pages Posted: 24 Nov 2012 Last revised: 29 Jul 2015
Date Written: March 24, 2015
This 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.
Keywords: stock allocation, consumption, loss-aversion, transform analysis
JEL Classification: G11, G12
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