Optimal asset allocation under linear loss aversion

Fortin, Ines; Hlouskova, Jaroslava

doi:10.1016/j.jbankfin.2011.03.023

Cited by 50 publications

(15 citation statements)

References 34 publications

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“…The first solution applies to households with lower discount factors (δ ≤ δ + ), which put relatively more emphasis on the well-being in the present and near future and thus display a high time preference, while the second applies to households with higher discount factors (δ > δ + ), which care relatively more about the distant future and discount future utility at a lower rate and thus show a low time preference. The threshold value δ + separating the two types is a function of the rates r f , r g and r b , of the probability of the good state of nature p and of the curvature parameter γ, see equation (17). Note that it is increasing in p and γ while it is decreasing in r f , all other things equal.…”

Section: Propositionmentioning

confidence: 99%

The consumption–investment decision of a prospect theory household: A two-period model

Hlouskova

Fortin

Tsigaris

2017

Journal of Mathematical Economics

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Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in AbstractThis study extends the literature on portfolio choice under prospect theory preferences by introducing a two-period life cycle model, where the household decides on optimal consumption and investment in a portfolio with one risk-free and one risky asset. The optimal solution depends primarily on the household's choice of the present value of the consumption reference levels relative to the present value of its endowment income. If the present value of the consumption reference levels is set below the present value of endowment income, then the household behaves in such a way to avoid relative losses in consumption in any present or future state of nature (good or bad). As a result the degree of loss aversion does not directly affect optimal consumption and risk taking activity. However, it must be sufficiently high in order to rule out outcomes with relative losses. On the other hand, if the present value of the consumption reference levels is set exactly equal to the present value of the endowment income, i.e., the household sets its reference levels such that they are in balance with its income, then the household's optimal consumption is the reference consumption in both periods and the household will not invest in the risky asset. Finally, if the present value of the household's consumption reference levels is set above the present value of its endowment income, then the household cannot avoid experiencing a relative loss in consumption, either now or in the future. As a result, loss aversion directly affects consumption and risky investment. Reference levels play a significant role in consumption and risk taking activity. In most cases the household will "follow the Joneses" if the reference levels are set equal to the consumption levels of the Joneses. Independent of how consumption reference levels are set, being more ambitious, i.e., increasing one's reference levels, will result in less happiness. The only case when this is not true is when reference levels increase with growing income (and the present value of reference levels is set below the present value of endowment income).

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Section: Propositionmentioning

confidence: 99%

The consumption–investment decision of a prospect theory household: A two-period model

Hlouskova

Fortin

Tsigaris

2017

Journal of Mathematical Economics

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“…For comparison, I also analyse returns and Sharpe ratio of the consumption insurer and those of an investor with power utility of consumption. A comprehensive analysis of the portfolio performance for the different cases of loss aversion over financial wealth is provided by Fortina andHlouskovaa (2011) andZakamouline (2014).…”

Section: Performance Of Optimal Portfoliosmentioning

confidence: 99%

“…Hens and Vlcek (2011) study the relation between loss aversion and the disposition effect. Fortina and Hlouskovaa (2011) examine the investment strategy of linear loss averse investors for different dependence structure of assets returns, namely, Gaussian copula and Clayton copula. Frühwirth and Mikula (2008) study the saving plans of loss averse investors.…”

Section: Introductionmentioning

confidence: 99%

Optimal Consumption and Portfolio Choice with Loss Aversion

Curatola

2016

SSRN Journal

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In their seminal paper, Kahneman and Tversky (1979) suggest that investors are more sensitive to losses than gains and that they tend to be risk seeking after losses and risk averse after gains, rather than purely risk-averse as postulated by the classical portfolio theory. Since then many researcher have incorporated loss aversion into the theory of portfolio and studied its implications for the choice of risky assets. This literature typically applies the idea of loss aversion to the return of risky assets or to fluctuations of financial wealth, around a certain reference point. However in their seminal paper, Kahneman and Tversky argue that loss aversion is a general mental framework that can be applied to any kind of choice whose outcomes can be coded in terms of gains and losses, and not only to stock returns. Motivated by this observation, I analyse the portfolio problem of an investor who is loss averse over consumption relative to a time-varying reference level. At any point in time the investor decides how to allocate wealth between consumption, risk-free and risky assets. In addition, the reference level of consumption evolves over time and is given by a weighted average of past and current consumption.I show that loss aversion changes the traditional consumption smoothing behavior. The loss averse agent smooths consumption only in good time (i.e., when the consumption good is cheap) and reduces consumption to the subsistence level in bad times (i.e., when the consumption good is expensive). The particular nature of the optimal consumption strategy implies that the investor's optimal portfolio has two components: a standard mean variance component and a gambling portfolio consisting of aggressive investments in stocks. The weight assigned to these two portfolios is time varying. In good times, the loss averse investor wishes to maximize the probability that his/her consumption stays above the reference level and the weight assigned to the mean variance portfolio increases. In bad times, the consumption smoothing strategy is abandoned and the investor opts for a gambling for resurrection strategy, thus rebalancing his/her portfolio toward risky assets.This consumption-investment strategy differs from what suggested by the traditional portfolio theory and is consistent with several recent stylized facts about investors' behaviour, such as the pro-cyclical behavior of consumption smoothing, or the tendency of many individual investors to increase their equity position during the recent financial crisis. Optimal Consumption and Portfolio Choice with Loss AversionGiuliano Curatola * Goethe Universität Frankfurt March 16, 2016Abstract This paper analyses the consumption-investment problem of a loss averse investor equipped with s-shaped utility over consumption relative to a time-varying reference level. Optimal consumption exceeds the reference level in good times and descend to the subsistence level in bad times. Accordingly, the optimal portfolio is dominated by a mean-variance component in good times and...

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“…(25) and (26). Therefore, the value should be calculated and , as the mean-reversion strength, should be set appropriate as it is the key factor which reflects the condition of future market.…”

Section: Research Articlementioning

confidence: 99%

“…The most important reason is when is high, the return and variance of real estate in M-period are also high according to Eqs. (25) and (26). Furthermore, the Eq.…”

Section: Groupmentioning

confidence: 99%

Portfolio management for assets with multiscale risk structure

Liu¹,

Zhang²

2013

j coupled syst multiscale dyn

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Any financial market is a coupled system where economic, market and human factors interact between themselves. It is also a multiscale system with various asstes having their own risk sructure in multiple time scales depending on investors' holding periods. In this paper, we will study a portfolio of mixed asset classes consisting of stock, bond and real estate. Real estate has a very different risk structure from stock and bond due to its illiquidity nature. The risk for real estate is holding period dependent while the risk for stock and bond can be assumed to be holding period independent. Therefore the risk for such mixed portfolio has multiple scales in time. Here we introduce a mean reversion model for the return of real estate asset. We intend to explore the effect of various parameters, including the strength of mean-reversion, risk-aversion coefficient and investment horizon etc. on investors' optimal asset allocation with real estate. We assume the investment opportunity of real estate varies with investment horizons while the return and variance of stock market and Tbond follow a constant pattern. We believe this is the first attempt to use a mean-reversion model in real estate market and the result we got from this research provides more reliable and practical suggestion for investors with different features and pursuits.

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Optimal asset allocation under linear loss aversion

Cited by 50 publications

References 34 publications

The consumption–investment decision of a prospect theory household: A two-period model

The consumption–investment decision of a prospect theory household: A two-period model

Optimal Consumption and Portfolio Choice with Loss Aversion

Portfolio management for assets with multiscale risk structure

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