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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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File URL: http://www.dnb.nl/binaries/wo0741_tcm46-146027.pdf
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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. 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.
  2. 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.).
  3. 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.
  4. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
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  8. Francisco Gomes & Alexander Michaelides, 2003. "Portfolio Choice With Internal Habit Formation: A Life-Cycle Model With Uninsurable Labor Income Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 729-766, October.
  9. Martin Browning & Thomas Crossley, 2001. "The life-cycle model of consumption and saving," IFS Working Papers W01/15, Institute for Fiscal Studies.
  10. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  11. 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.
  12. Martin Browning & Annamaria Lusardi, 1995. "Household Saving: Micro Theories and Micro Facts," Department of Economics Working Papers 1995-02, McMaster University.
  13. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, 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. David A. Chapman, 1998. "Habit Formation and Aggregate Consumption," Econometrica, Econometric Society, vol. 66(5), pages 1223-1230, September.
  16. 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.
  17. 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.
  18. Aylin Seckin, 2000. "Consumption with Habit Formation," CIRANO Working Papers 2000s-39, CIRANO.
  19. Thaler, Richard H, 1994. "Psychology and Savings Policies," American Economic Review, American Economic Association, vol. 84(2), pages 186-92, May.
  20. 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.
  21. Aylin Seckin, 2000. "Habit Formation: A Kind of Prudence?," CIRANO Working Papers 2000s-42, CIRANO.
  22. 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.
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