Optimal Consumption and Portfolio Choice with Loss Aversion

SAFE Working Paper No. 130

40 Pages Posted: 19 Mar 2016

See all articles by Giuliano Curatola

Giuliano Curatola

University of Siena - Department of Economics and Statistics; Goethe University Frankfurt - Research Center SAFE

Multiple version iconThere are 2 versions of this paper

Date Written: March 16, 2016

Abstract

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: Loss-aversion, Habit-formation, Consumption-portfolio choice

JEL Classification: G11, G12

Suggested Citation

Curatola, Giuliano, Optimal Consumption and Portfolio Choice with Loss Aversion (March 16, 2016). SAFE Working Paper No. 130. Available at SSRN: https://ssrn.com/abstract=2749498 or http://dx.doi.org/10.2139/ssrn.2749498

Giuliano Curatola (Contact Author)

University of Siena - Department of Economics and Statistics ( email )

Piazza San Francesco 7
Siena, Siena 53100
Italy

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

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