An Intertemporal Preference with Loss Aversion: Consumption and Risk Attitude

Abstract

We investigate the consumption and portfolio selection problem of an agent who faces the partial irrreversibility of consumption decisions, formalizing the classic theory proposed by Duesenberry (1949). Consumption irreversibility is modeled by mental utility costs. The derived preference exhibits intertemporal loss aversion (ILA) toward consumption changes in the sense that the reference point turns out to be the previous consumption level in time. The consumption policy involves an inaction interval for the consumption-wealth ratio, which can explain the four stylized facts about consumption: excess smoothness, excess sensitivity, their disappearance for large shocks, and asymmetric sensitivities to wealth (income) shocks. The implied risk aversion increases with ILA except at the boundary of the inaction interval, which generates time-varying risk aversion that can exhibit sometimes extreme risk aversion and at other times fairly low risk aversion.

Keywords: intertemporal preference, loss aversion, risk aversion, consumption ratcheting, irreversibility of consumption decision

JEL Classification: C61, D11, D15, E21, G11