Portfolio Rebalancing with Realization Utility
50 Pages Posted: 30 Jan 2022 Last revised: 7 Mar 2022
Date Written: January 29, 2022
We develop a model where a realization-utility investor (Barberis and Xiong, 2009, 2012; Ingersoll and Jin, 2013) optimally targets her liquid-illiquid wealth ratio at a constant w∗. By saving in the risk-free asset (w∗ > 0), she makes smaller bets in the illiquid asset and realizes gains/losses more frequently. By leveraging (w∗ < 0), she makes bets larger than her equity and realizes gains/losses less frequently. For a discontinuous/jump-diffusion price process, the solution features four regions: loss-realization, gain-realization, and two disconnected (deep-loss and normal) holding regions. We generate a quantitatively significant non-monotonic propensity to realize losses consistent with evidence.
Keywords: prospect theory; loss aversion; option value; disposition effect
JEL Classification: D03, G11, G12
Suggested Citation: Suggested Citation