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

This paper explicitly derives the optimal dynamic consumption and portfolio choice of a loss averse agent who endogenously updates his reference level. His optimal choice seeks protection against consumption losses due to downside financial shocks. This induces a (soft) guarantee on consumption and is due to loss aversion. Furthermore, his optimal consumption choice gradually adjusts to financial shocks. This resembles the payout streams of nancial plans that respond sluggishly, smoothing investment returns to reduce payout volatility, and is due to endogenous updating. The welfare losses associated with various suboptimal consumption and portfolio strategies are also evaluated. They can be substantial.

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