Optimal portfolio choice under loss aversion

Arjan Berkelaar and Roy Kouwenberg

No EI 2000-08/A, Econometric Institute Research Papers from Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute

Abstract: Prospect theory and loss aversion play a dominant role in behavioral finance. In this paper we derive closed-form solutions for optimal portfolio choice under loss aversion. When confronted with gains a loss averse investor behaves similar to a portfolio insurer. When confronted with losses, the investor aims at maximizing the probability that terminal wealth exceeds his aspiration level. Our analysis indicates that a representative agent model with loss aversion cannot resolve the equity premium puzzle. We also extend the martingale methodology to allow for more general utility functions and provide a simple approach to incorporate skewed and fat-tailed return distributions.

Keywords: behavioral finance; loss aversion; optimal asset allocation (search for similar items in EconPapers)
Date: 2000-03-01
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Citations: View citations in EconPapers (15)

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Journal Article: Optimal Portfolio Choice under Loss Aversion (2004)
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