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Failing to Foresee the Updating of the Reference Point Leads to Time-Inconsistent Investment

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  • Moris S. Strub

    (Business School, Southern University of Science and Technology, Shenzhen, 518055 Guangdong, China)

  • Duan Li

    (School of Data Science, City University of Hong Kong, Kowloon Tong, Kowloon, Hong Kong)

Abstract

The current literature on behavioral portfolio optimization with reference point updating assumes that the decision maker foresees how the reference point will evolve and thus solves a time-consistent problem formulation. Empirical findings, however, suggest that decision makers often fail to foresee the updating of the reference point and consequently make time-inconsistent decisions. We analyze and compare the optimal investment strategies for a discrete time behavioral portfolio optimization problem with loss-aversion and time-varying reference points under both the time-consistent and time-inconsistent framework and for different updating rules for the reference point. There is only one framework predicting realistic investment behavior: the decision maker fails to foresee the updating of the reference point and thus faces a time-inconsistent problem, solves for a dynamically optimal strategy, and updates the reference point in a nonrecursive manner.

Suggested Citation

  • Moris S. Strub & Duan Li, 2020. "Failing to Foresee the Updating of the Reference Point Leads to Time-Inconsistent Investment," Operations Research, INFORMS, vol. 68(1), pages 199-213, January.
    • Handle: RePEc:inm:oropre:v:68:y:2020:i:1:p:199-213
    DOI: 10.1287/opre.2019.1872
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    2. Jia Yue & Ming-Hui Wang & Nan-Jing Huang, 2022. "Global Optimal Consumption–Portfolio Rules with Myopic Preferences and Loss Aversion," Computational Economics, Springer;Society for Computational Economics, vol. 60(4), pages 1427-1455, December.
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    4. Balter, Anne G. & Mahayni, Antje & Schweizer, Nikolaus, 2021. "Time-consistency of optimal investment under smooth ambiguity," European Journal of Operational Research, Elsevier, vol. 293(2), pages 643-657.

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