Consumption and portfolio choice under loss aversion and endogenous updating of the reference level

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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. A medium wealth level yields a stronger incentive to protect current consumption than a high or low wealth level. Furthermore, he adopts a conservative investment strategy in normal states and typically a more aggressive strategy in good or 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 easily exceeds 10%.
Original languageEnglish
JournalManagement Science
Publication statusAccepted/In press - May 2019

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Keywords

  • loss aversion
  • endogenous reference level
  • prospect theory
  • optimal consumption choice
  • optimal portfolio choice

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