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Optimal portfolio choice under loss aversion

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Author Info
Berkelaar, A.B.
Kouwenberg, R.R.P. (Erasmus 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.

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File URL: http://hdl.handle.net/1765/1641
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Publisher Info
Paper provided by Erasmus University Rotterdam, Econometric Institute in its series Econometric Institute Report with number EI 2000-08/A Revision_Date: 2009-07-29.

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Date of creation: 01 Mar 2000
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Handle: RePEc:dgr:eureir:1765001641

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Related research
Keywords: optimal asset allocation; behavioral finance; loss aversion;

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  1. Andrew Ang & Geert Bekaert & Jun Liu, 2000. "Why Stocks May Disappoint," NBER Working Papers 7783, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  2. Mark Grinblatt & Bing Han, 2001. "The Disposition Effect and Momentum," University of California at Los Angeles, Anderson Graduate School of Management 1019, Anderson Graduate School of Management, UCLA. [Downloadable!]
    Other versions:
  3. Arjen Siegmann & André Lucas, 2002. "Explaining Hedge Fund Investment Styles by Loss Aversion," Tinbergen Institute Discussion Papers 02-046/2, Tinbergen Institute. [Downloadable!]
  4. Ulrich Schmidt & Horst Zank, 2005. "What is Loss Aversion?," Journal of Risk and Uncertainty, Springer, vol. 30(2), pages 157-167, January. [Downloadable!] (restricted)
    Other versions:
  5. A. Berkelaar & R. Kouwenberg, 2000. "From boom til bust," Econometric Institute Report 196, Erasmus University Rotterdam, Econometric Institute. [Downloadable!]
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This page was last updated on 2009-12-2.

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