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Shortfall aversion

Author

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  • Paolo Guasoni
  • Gur Huberman
  • Dan Ren

Abstract

Shortfall aversion reflects the higher utility loss of spending cuts from a reference than the utility gain from similar spending increases. Inspired by Prospect Theory's loss aversion and the peak‐end rule, this paper posits a model of utility from spending scaled by past peak spending. In contrast to traditional models, which call for spending rates proportional to wealth, the optimal policy in this model implies a constant spending rate equal to the historical peak when wealth is relatively large. The spending rate increases when wealth reaches a model‐determined multiple of peak spending. In 1926–2015, shortfall‐averse spending is smooth and typically increasing.

Suggested Citation

  • Paolo Guasoni & Gur Huberman & Dan Ren, 2020. "Shortfall aversion," Mathematical Finance, Wiley Blackwell, vol. 30(3), pages 869-920, July.
    • Handle: RePEc:bla:mathfi:v:30:y:2020:i:3:p:869-920
    DOI: 10.1111/mafi.12239
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    References listed on IDEAS

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