Optimal consumption and portfolio choice with loss aversion

Giuliano Curatola

No 130, SAFE Working Paper Series from Leibniz Institute for Financial Research SAFE

Abstract: This paper analyses the consumption-investment problem of a loss averse investor equipped with s-shaped utility over consumption relative to a time-varying reference level. Optimal consumption exceeds the reference level in good times and descend to the subsistence level in bad times. Accordingly, the optimal portfolio is dominated by a mean-variance component in good times and rebalanced more aggressively toward stocks in bad times. This consumption-investment strategy contrasts with customary portfolio theory and is consistent with several recent stylized facts about investors' behaviour. I also analyse the joint effect of loss aversion and persistence of the reference level on optimal choices. Finally, the strategy of the loss averse investor outperforms the conventional Merton-style strategies in bad times, but tend to be dominated by the conventional strategies in good times.

Keywords: Loss-aversion; Habit-formation; Consumption-portfolio choice (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2016
New Economics Papers: this item is included in nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:safewp:130

DOI: 10.2139/ssrn.2749498

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