Consumption and Portfolio Choice under Loss Aversion and Endogenous Updating of the Reference Level

47 Pages Posted: 19 Dec 2014 Last revised: 1 Dec 2017

See all articles by Servaas van Bilsen

Servaas van Bilsen

University of Amsterdam - Department of Quantitative Economics

Roger J. A. Laeven

University of Amsterdam - Department of Quantitative Economics (KE)

Theo Nijman

Tilburg University - Tilburg University School of Economics and Management

Multiple version iconThere are 2 versions of this paper

Date Written: November 29, 2017

Abstract

We explicitly derive and explore the optimal consumption and portfolio policies of a loss- averse individual who endogenously updates his reference level over time. We find that he protects his current consumption by delaying painful reductions in consumption after a drop in wealth, and increasingly so with higher degrees of endogeneity. The incentive to protect current consumption is stronger with a medium wealth level than with a high or low wealth level. Furthermore, this individual adopts a conservative investment strategy in normal states and typically a more aggressive strategy in good and bad states. Endogeneity of the reference level increases overall risk-taking and generates an incentive to reduce risk exposure with age even without human capital. The welfare loss that this individual would suffer under the conventional CRRA consumption and portfolio policies typically exceeds 10%.

Keywords: Loss Aversion; Endogenous Reference Level; Prospect Theory; Optimal Consumption Choice; Optimal Portfolio Choice

JEL Classification: D81, D91, G02, G11

Suggested Citation

van Bilsen, Servaas and Laeven, Roger Jean Auguste and Nijman, Theo E., Consumption and Portfolio Choice under Loss Aversion and Endogenous Updating of the Reference Level (November 29, 2017). Netspar Discussion Paper No. 11/2014-048, Available at SSRN: https://ssrn.com/abstract=2540034 or http://dx.doi.org/10.2139/ssrn.2540034

Servaas Van Bilsen (Contact Author)

University of Amsterdam - Department of Quantitative Economics ( email )

Roetersstraat 11
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Roger Jean Auguste Laeven

University of Amsterdam - Department of Quantitative Economics (KE) ( email )

Valckenierstraat 65-67
Amsterdam, 1018 XE
Netherlands
+31 20 525 4252 (Phone)

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

Theo E. Nijman

Tilburg University - Tilburg University School of Economics and Management ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2342 (Phone)
+31 13 466 3280 (Fax)

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