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Myopic loss aversion, reference point, and money illusion

Xue Dong He and Xun Yu Zhou

Quantitative Finance, 2014, vol. 14, issue 9, 1541-1554

Abstract: We use the portfolio selection model presented in He and Zhou [ Manage. Sci. , 2011, 57 , 315-331] and the NYSE equity and US treasury bond returns for the period 1926-1990 to revisit Benartzi and Thaler's myopic loss aversion theory. Through an extensive empirical study, we find that in addition to the agent's loss aversion and evaluation period, his reference point also has a significant effect on optimal asset allocation. We demonstrate that the agent's optimal allocation to equities is consistent with market observation when he has reasonable values of degree of loss aversion, evaluation period and reference point. We also find that the optimal allocation to equities is sensitive to these parameters. We then examine the implications of money illusion for asset allocation. Finally, we extend the model to a dynamic setting.

Date: 2014
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