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Optimal portfolio choice with loss aversion over consumption

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  • Curatola, Giuliano

Abstract

This paper analyses the consumption–investment problem of a loss averse investor with an s-shaped utility over consumption relative to a time-varying reference level. Optimal consumption exceeds the reference level in good times and descends 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 investor’ behavior. I also analyze 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 tends to be dominated by the conventional strategies in good times.

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  • Curatola, Giuliano, 2017. "Optimal portfolio choice with loss aversion over consumption," The Quarterly Review of Economics and Finance, Elsevier, vol. 66(C), pages 345-358.
    • Handle: RePEc:eee:quaeco:v:66:y:2017:i:c:p:345-358
    DOI: 10.1016/j.qref.2017.04.003
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    6. Servaas van Bilsen & Roger J. A. Laeven & Theo E. Nijman, 2020. "Consumption and Portfolio Choice Under Loss Aversion and Endogenous Updating of the Reference Level," Management Science, INFORMS, vol. 66(9), pages 3927-3955, September.
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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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