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
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Consumption and Portfolio Choice Under Loss Aversion and Endogenous Updating of the Reference Level
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: Suggested Citation