Investors Facing Risk: Loss Aversion and Wealth Allocation Between Risky and Risk-Free Assets

Abstract

This paper studies the impact of loss aversion on decisions regarding the allocation of wealth between risky and risk-free assets. We use a Value-at-Risk portfolio model with endogenous desired risk levels that are individually determined in an extended prospect theory framework. This framework allows for the distinction between gains and losses with respect to a subjective reference point as in the original prospect theory, but also for the influence of past performance on the current perception of the risky portfolio value. We show how the portfolio evaluation frequency impacts investor decisions and attitudes when facing financial losses and analyze the role of past gains and losses in the current wealth allocation. The perceived portfolio value exhibits distinct evolutions in two frequency segments delimitated by what we consider to be the optimal evaluation horizon of one year. Our empirical results suggest that previous research relying on VaR underestimates the aversion of real individual investors to financial losses.

Investors Facing Risk II: Loss Aversion and Wealth Allocation When Utility is Derived from Consumption and Narrowly Framed Financial Investments

“…Several ideas developed in these papers have already been incorporated by Rengifo and Trifan (2006) into the portfolio optimization setting developed in Campbell, Huisman, and Koedijk (2001). In particular, Rengifo and Trifan (2006) describe how individual perceptions of risky financial investments impact on the optimal composition of a risky portfolio and the money to be invested in risk-free assets. Their focus lies thus on capital allocation decisions of non-professional investors, where finding the optimal mix of risky assets is assumed to represent the task of professional portfolio managers.…”

“…In this context, individual utility is considered to exclusively originate in financial wealth fluctuations. Thus, the designed utility setting in Rengifo and Trifan (2006) can be regarded as one-sided.…”

“…Our non-professional investors have now to decide upon the optimal wealth allocation between consumption and financial investments in general, where the latter category offers a further choice between the risky portfolio and a risk-free asset. We adopt the formal views in Rengifo and Trifan (2006) regarding the subjectively perceived value of risky investments (denoted as the prospective value) and how it enters the decision problem of non-professional investors. In addition, we rely on two theoretical approaches proposed in Barberis and Huang (2004a,b), according to which investors decisions rely on the maximization of either expected utility or of recursive non-expected utility with first-order risk aversion.…”

“…Moreover, for a better description of the individual attitude towards financial losses, two further measures used in Rengifo and Trifan (2006) are adopted, namely the loss aversion index (LAi) and the global first-order risk aversion (gRA).…”

“…To this end, we rely on the same data set as in Rengifo and Trifan (2006), consisting of the SP500 and the 10-year bond nominal returns, as proxies for a well diversified risky portfolio and the risk-free investment, respectively. In addition, we employ aggregate per-capita consumption data that allow us to analyze the investor loss attitude and the decisions concerning the wealth allocation for two different evaluation frequencies of the risky-portfolio performance (of one year and three months).…”