Portfolio Choice and Trading Volume with Loss Averse Investors

Abstract

This paper presents a formal model of portfolio choice and stock trading volume with loss-averse investors. The demand function for risky assets is discontinuous and non-monotonic: as wealth rises beyond a threshold investors follow a generalized portfolio insurance strategy. This behavior is consistent with the evidence in favor of the disposition effect. In addition, loss-averse investors will not hold stocks unless the equity premium is quite high. The elasticity of the aggregate demand curve changes substantially, depending on the distribution of wealth across investors. In an equilibrium setting the model typically generates positive correlation between trading volume and stock return volatility, but suggests that this relationship should be non-linear.

Keywords: Loss Aversion, First-Order Risk Aversion, Portfolio Insurance, Portfolio Choice, Stock Market Participation, Trading Volume

JEL Classification: G11, G12