Investors Facing Risk II: Loss Aversion and Wealth Allocation When Utility is Derived from Consumption and Narrowly Framed Financial Investments

47 Pages Posted: 23 Feb 2007

See all articles by Erick W. Rengifo

Erick W. Rengifo

Fordham University - Department of Economics - Center for International Policy Studies (CIPS)

Emanuela Trifan

Catholic University of Leuven, Center for Operation Research and Econometrics (CORE); Darmstadt University of Technology - Institute of Economics - Department of Applied Econometrics; Department of Economics, Chair of Econometrics

Date Written: February 2007

Abstract

This paper studies the attitude of non-professional investors towards financial losses and their decisions concerning wealth allocation among consumption, risky, and risk-free financial assets. We employ a two-dimensional utility setting in which both consumption and financial wealth fluctuations generate utility. The perception of financial wealth is modelled in an extended prospect-theory framework, that accounts for both the distinction between gains and losses with respect to a subjective reference point and the impact of past performance on the current perception of the risky portfolio value. The decision problem is addressed in two distinct equilibrium settings in the aggregate market with a representative investor, namely with expected and non-expected utility. Empirical estimations performed on the basis of real market data and for various parameter configurations show that both settings similarly describe the attitude towards financial losses. Yet, the recommendations regarding wealth allocation are different. Maximizing expected utility results on average in low total-wealth percentages dedicated to consumption, but supports myopic loss aversion. Non-expected utility yields more reasonable assignments to consumption but also a high preference for risky assets. In this latter setting, myopic loss aversion holds solely when financial wealth fluctuations are viewed as the main utility source and in very soft form.

Keywords: prospect theory, Value-at-Risk, loss aversion, expected utility, non-expected utility

JEL Classification: C32, C35, G10

Suggested Citation

Rengifo, Erick W. and Trifan, Emanuela, Investors Facing Risk II: Loss Aversion and Wealth Allocation When Utility is Derived from Consumption and Narrowly Framed Financial Investments (February 2007). Available at SSRN: https://ssrn.com/abstract=964669 or http://dx.doi.org/10.2139/ssrn.964669

Erick W. Rengifo

Fordham University - Department of Economics - Center for International Policy Studies (CIPS) ( email )

United States
0017188174061 (Phone)
0017188173518 (Fax)

Emanuela Trifan (Contact Author)

Catholic University of Leuven, Center for Operation Research and Econometrics (CORE) ( email )

34, Voie du Roman Pays
Louvain-la-Neuve, 1348
Belgium

Darmstadt University of Technology - Institute of Economics - Department of Applied Econometrics ( email )

Residenzschloss, Marktplatz 15
Darmstadt, 64283
Germany
+49(0)6151 166506 (Phone)
+49(0)6151 165652 (Fax)

HOME PAGE: http://www.tu-darmstadt.de/fb/fb1/vwl2/

Department of Economics, Chair of Econometrics ( email )

Gr├╝neburgplatz 1
Frankfurt am Main, 60323
Germany

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