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Shortfall allowed: loss aversion and habit formation

  • Arjen Siegmann

In this paper we analyze a model of consumption and investment when preferences are loss averse around a habit level and investment yields an uncertain return. Loss aversion is the most natural way of modeling the presence of a habit as it explicitly models aversion to below-habit consumption. Existing approaches either neglect the possibility of below-habit consumption or model habit formation by dividing consumption through a habit. Confronting the traditional model using ratios with the outcome under loss aversion shows that the loss averse model yields a more natural interpretation thus appears more realistic. Starting with an analytical solution for a piecewise-linear utility function, the results are found to be robust for the more general Kahneman-Tversky formulation of the value function.

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Paper provided by Netherlands Central Bank, Research Department in its series WO Research Memoranda (discontinued) with number 741.

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Length: 26 pages
Date of creation: Sep 2003
Date of revision:
Handle: RePEc:dnb:wormem:741
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  1. David Bowman & Deborah Minehart & Matthew Rabin, 1994. "Loss aversion in a consumption/savings model," International Finance Discussion Papers 492, Board of Governors of the Federal Reserve System (U.S.).
  2. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  3. Aylin Seckin, 2000. "Habit Formation: A Kind of Prudence?," CIRANO Working Papers 2000s-42, CIRANO.
  4. Detemple, Jerome B & Zapatero, Fernando, 1991. "Asset Prices in an Exchange Economy with Habit Formation," Econometrica, Econometric Society, vol. 59(6), pages 1633-57, November.
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  9. David A. Chapman, 1998. "Habit Formation and Aggregate Consumption," Econometrica, Econometric Society, vol. 66(5), pages 1223-1230, September.
  10. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 1-90, Wharton School Rodney L. White Center for Financial Research.
  11. Martin Browning & Thomas F. Crossley, 2001. "The Life-Cycle Model of Consumption and Saving," Journal of Economic Perspectives, American Economic Association, vol. 15(3), pages 3-22, Summer.
  12. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  13. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  14. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  15. Gomes, Francisco J & Michaelides, Alexander, 2003. "Portfolio Choice with Internal Habit Formation: A Life-Cycle Model with Uninsurable Labour Income Risk," CEPR Discussion Papers 3868, C.E.P.R. Discussion Papers.
  16. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  17. Aizenman, Joshua, 1998. "Buffer stocks and precautionary savings with loss aversion," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 931-947, December.
  18. Egil Matsen, 2001. "Habit Persistence and Welfare Gains from International Asset Trade," Working Paper Series 0102, Department of Economics, Norwegian University of Science and Technology.
  19. Thaler, Richard H, 1994. "Psychology and Savings Policies," American Economic Review, American Economic Association, vol. 84(2), pages 186-92, May.
  20. David A. Chapman, 2002. "Does Intrinsic Habit Formation Actually Resolve the Equity Premium Puzzle?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 5(3), pages 618-645, July.
  21. Aylin Seckin, 2000. "Consumption with Habit Formation," CIRANO Working Papers 2000s-39, CIRANO.
  22. Jerome B. Detemple & Fernando Zapatero, 1992. "Optimal Consumption-Portfolio Policies With Habit Formation," Mathematical Finance, Wiley Blackwell, vol. 2(4), pages 251-274.
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