Dynamic Consumption and Portfolio Choice under Prospect Theory

Abstract

This paper explicitly derives the optimal dynamic consumption and portfolio choice of an individual with prospect theory preferences. The individual is loss averse, endogenously updates his reference level over time, and distorts probabilities. We show that the optimal consumption strategy is rather insensitive to economic shocks. In particular, in case the individual sufficiently overweights unlikely unfavorable events, our model generates an endogenous floor on consumption. As a result, an individual with prospect theory preferences typically implements a (very) conservative portfolio strategy. We discuss implications of our results for the design of investment-linked annuity products.

Keywords: Loss Aversion, Endogenous Reference Level, Optimal Consumption Choice, Optimal Portfolio Choice, Probability Weighting, Optimal Annuity Design

JEL Classification: D81, D91, G02, G11