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Optimal portfolio choice under loss aversion

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  • Berkelaar, A.B.
  • Kouwenberg, R.R.P.

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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Bibliographic Info

Paper provided by Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute in its series Econometric Institute Research Papers with number EI 2000-08/A.

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Date of creation: 01 Mar 2000
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Handle: RePEc:ems:eureir:1641

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

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