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Optimal consumption and portfolio choice with loss aversion

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  • Curatola, Giuliano

Abstract

This paper analyses the consumption-investment problem of a loss averse investor equipped with s-shaped utility over consumption relative to a time-varying reference level. Optimal consumption exceeds the reference level in good times and descend to the subsistence level in bad times. Accordingly, the optimal portfolio is dominated by a mean-variance component in good times and rebalanced more aggressively toward stocks in bad times. This consumption-investment strategy contrasts with customary portfolio theory and is consistent with several recent stylized facts about investors' behaviour. I also analyse the joint effect of loss aversion and persistence of the reference level on optimal choices. Finally, the strategy of the loss averse investor outperforms the conventional Merton-style strategies in bad times, but tend to be dominated by the conventional strategies in good times.

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  • Curatola, Giuliano, 2016. "Optimal consumption and portfolio choice with loss aversion," SAFE Working Paper Series 130, Leibniz Institute for Financial Research SAFE.
    • Handle: RePEc:zbw:safewp:130
    DOI: 10.2139/ssrn.2749498
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    More about this item

    Keywords

    Loss-aversion; Habit-formation; Consumption-portfolio choice;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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