Intertemporal Preference with Loss Aversion: Consumption and Risk Attitude

Abstract

We study the consumption and portfolio selection problem of economic agents who face consumption irreversibility: there is disutility from changing consumption levels. The derived preference exhibits loss aversion toward a consumption gamble with the previous consumption level being the reference point. The optimization problem involves a non-monotonic and non-concave utility function. We derive a closed-form solution by combining a duality method and the super-contact principle. We show that the consumption policy involves an inaction interval for the consumption-permanent income ratio, which are consistent with various empirical regularities about consumption. The effective risk aversion derived from agents' optimal portfolio choice exhibits an inverted U-shape in the inaction interval.

Keywords: consumption irreversibility, intertemporal loss aversion, excess sensitivity and smoothness, asymmetric sensitivities, consumption heterogeneity, U-shaped risky share

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