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

Servaas van Bilsen (), Roger Laeven and Theo E. Nijman ()
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Servaas van Bilsen: Amsterdam School of Economics, University of Amsterdam, 1001 NJ Amsterdam, Netherlands
Theo E. Nijman: Department of Finance, Tilburg University, 5000 LE Tilburg, Netherlands

Management Science, 2020, vol. 66, issue 9, 3927-3955

Abstract: We explicitly derive and explore the optimal consumption and portfolio policies of a loss-averse individual who endogenously updates his or her reference level over time. We find that the individual protects 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 constant relative risk aversion (CRRA) consumption and portfolio policies easily exceeds 10%.

Keywords: loss aversion; endogenous reference level; prospect theory; optimal consumption choice; optimal portfolio choice (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (12)

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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:66:y:2020:i:9:p:3927-3955

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