Optimal Portfolio Choice under Loss Aversion

Arjan B. Berkelaar, Roy Kouwenberg and Thierry Post
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Arjan B. Berkelaar: World Bank
Thierry Post: Erasmus University Rotterdam

The Review of Economics and Statistics, 2004, vol. 86, issue 4, 973-987

Abstract: This paper analyzes the optimal investment strategy for loss averse investors, assuming a complete market and general Ito processes for the asset prices. The loss-averse investor follows a partial portfolio insurance strategy. When the investor's planning horizon is short (less than 5 years), he or she considerably reduces the initial portfolio weight of stocks compared to an investor with smooth power utility. The empirical section of the paper estimates the level of loss aversion implied by historical U.S. stock market data, using a representative agent model. We find that loss aversion and risk aversion cannot be disentangled empirically. © 2004 President and Fellows of Harvard College and the Massachusetts Institute of Technology.

Date: 2004
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