Shortfall Aversion

48 Pages Posted: 25 Sep 2014

See all articles by Paolo Guasoni

Paolo Guasoni

Boston University - Department of Mathematics and Statistics; Dublin City University - School of Mathematical Sciences; University of Bologna - Department of Statistics

Gur Huberman

Columbia University - Columbia Business School, Finance

Dan Ren

University of Dayton

Multiple version iconThere are 3 versions of this paper

Date Written: July 2014

Abstract

Shortfall aversion reflects the higher utility loss of a spending cut from a reference point than the utility gain from a similar spending increase, in the spirit of Prospect Theory's loss aversion. This paper posits a model of utility of spending scaled by a function of past peak spending, called target spending. The discontinuity of the marginal utility at the target spending corresponds to shortfall aversion. According to the closed-form solution of the associated spending-investment problem, (i) the spending rate is constant and equals the historical peak for relatively large values of wealth/target; and (ii) the spending rate increases (and the target with it) when that ratio reaches its model-determined upper bound. These features contrast with traditional Merton-style models which call for spending rates proportional to wealth. A simulation using the 1926-2012 realized returns suggests that spending of the very shortfall averse is typically increasing and very smooth.

Keywords: consumption, endowments, loss aversion, portfolio choice

JEL Classification: G11, G12

Suggested Citation

Guasoni, Paolo and Guasoni, Paolo and Huberman, Gur and Ren, Dan, Shortfall Aversion (July 2014). CEPR Discussion Paper No. DP10064, Available at SSRN: https://ssrn.com/abstract=2501538

Paolo Guasoni (Contact Author)

Boston University - Department of Mathematics and Statistics ( email )

Boston, MA 02215
United States

Dublin City University - School of Mathematical Sciences ( email )

Dublin
Ireland

HOME PAGE: http://www.guasoni.com

University of Bologna - Department of Statistics ( email )

Bologna, 40126
Italy

Gur Huberman

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
New York, NY 10027
United States
(212) 854-5553 (Phone)

Dan Ren

University of Dayton ( email )

300 College Park
Dayton, OH 45469
United States

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