Failing to Foresee the Updating of the Reference Point Leads to Time-Inconsistent Investment

29 Pages Posted: 30 Aug 2017 Last revised: 4 Apr 2019

See all articles by Moris Simon Strub

Moris Simon Strub

Southern University of Science and Technology - Division of Information Systems and Management Engineering

Duan Li

Chinese University of Hong Kong; City University of Hong Kong

Date Written: April 3, 2019

Abstract

The current literature on behavioral portfolio optimization with reference point updating assumes that the decision maker foresees how the reference point will evolve and thus solves a time-consistent problem formulation. Empirical findings on the other hand suggest that decision makers often fail to foresee the updating of the reference point and consequently make time-inconsistent decisions. We analyze and compare the optimal investment strategies for a discrete-time behavioral portfolio optimization problem with loss-aversion and time-varying reference points under both the time-consistent and time-inconsistent framework and for different updating rules for the reference point. There is only one framework predicting realistic investment behavior: the decision maker fails to foresee the updating of the reference point and thus faces a time-inconsistent problem, solves for a dynamically optimal strategy and updates the reference point in a non-recursive manner.

Keywords: reference-dependent preferences, time-inconsistency, stochastic control, portfolio selection

JEL Classification: G02, G11

Suggested Citation

Strub, Moris Simon and Li, Duan, Failing to Foresee the Updating of the Reference Point Leads to Time-Inconsistent Investment (April 3, 2019). Available at SSRN: https://ssrn.com/abstract=3028089 or http://dx.doi.org/10.2139/ssrn.3028089

Moris Simon Strub

Southern University of Science and Technology - Division of Information Systems and Management Engineering ( email )

1088 Xueyuan Ave
Shenzhen, Guangdong
China

HOME PAGE: http://sites.google.com/view/morisstrub/home

Duan Li (Contact Author)

Chinese University of Hong Kong ( email )

Shatin, New Territories
Hong Kong

City University of Hong Kong

Tat Chee Avenue
Kowloon Tong
Kowloon
Hong Kong
852 3442 8591 (Phone)

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