Investors Facing Risk: Loss Aversion and Wealth Allocation Between Risky and Risk-Free Assets

56 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 impact of loss aversion on decisions regarding the allocation of wealth between risky and risk-free assets. We use a Value-at-Risk portfolio model with endogenous desired risk levels that are individually determined in an extended prospect theory framework. This framework allows for the distinction between gains and losses with respect to a subjective reference point as in the original prospect theory, but also for the influence of past performance on the current perception of the risky portfolio value. We show how the portfolio evaluation frequency impacts investor decisions and attitudes when facing financial losses and analyze the role of past gains and losses in the current wealth allocation. The perceived portfolio value exhibits distinct evolutions in two frequency segments delimitated by what we consider to be the optimal evaluation horizon of one year. Our empirical results suggest that previous research relying on fixed confidence portfolio risk levels underestimates the aversion of real individual investors to financial losses.

Keywords: prospect theory, loss aversion, capital allocation, Value-at-Risk, portfolio evaluation

JEL Classification: C32, C35, G10

Suggested Citation

Rengifo, Erick W. and Trifan, Emanuela, Investors Facing Risk: Loss Aversion and Wealth Allocation Between Risky and Risk-Free Assets (February 2007). Available at SSRN: https://ssrn.com/abstract=964674 or http://dx.doi.org/10.2139/ssrn.964674

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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