Optimal Consumption and Portfolio Choice with Loss Aversion
SAFE Working Paper No. 130
40 Pages Posted: 19 Mar 2016
Date Written: March 16, 2016
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: Suggested Citation