43 Pages Posted: 20 Jun 2014 Last revised: 28 Sep 2017
Date Written: March 9, 2017
Shortfall aversion reflects the higher utility loss of spending cuts from a reference than the utility gain from similar spending increases. Inspired by Prospect Theory's loss aversion and the peak-end rule, this paper posits a model of utility from spending scaled by past peak-spending. In contrast to traditional models, which call for spending rates proportional to wealth, the optimal policy in this model implies a constant spending rate equal to the historical peak when wealth is relatively large. The spending rate increases when wealth reaches a model-determined multiple of peak spending. In 1926-2015, shortfall-averse spending is smooth and typically increasing.
Keywords: loss aversion, portfolio choice, consumption, endowments
JEL Classification: G11, G12
Suggested Citation: Suggested Citation