Loss aversion, asymmetric market comovements, and the home bias
AbstractLoss aversion has been used to explain why a high equity premium might be consistent with plausible levels of risk aversion. The intuition is that the different utility impact of wealth gains and losses leads loss-averse investors to behave similarly to investors with high risk aversion. But if so, should these agents not perceive larger gains from international diversification than standard expected-utility preference agents with plausible levels of risk aversion? They might not, because comovements in international stock markets are asymmetric: Correlations are higher in market downturns than in upturns. This asymmetry dampens the gains from diversification relatively more for loss-averse investors. We analyze the portfolio problem of such an investor who has to choose between home and foreign equities in the presence of asymmetric comovement in returns. Perhaps surprisingly, in the context of the home bias puzzle we find that the loss-averse investors behave similarly to those with standard expected-utility preferences and plausible levels of risk aversion. We argue that preference specifications that appear to perform well with respect to the equity premium puzzle should be subjected to this "test."
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Bibliographic InfoPaper provided by Federal Reserve Bank of New York in its series Staff Reports with number 430.
Date of creation: 2010
Date of revision:
Other versions of this item:
- Amonlirdviman, Kevin & Carvalho, Carlos, 2010. "Loss aversion, asymmetric market comovements, and the home bias," Journal of International Money and Finance, Elsevier, vol. 29(7), pages 1303-1320, November.
- NEP-ALL-2010-02-27 (All new papers)
- NEP-CBE-2010-02-27 (Cognitive & Behavioural Economics)
- NEP-UPT-2010-02-27 (Utility Models & Prospect Theory)
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