Shortfall Aversion

Gur Huberman, Paolo Guasoni and Dan Ren

No 10064, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Shortfall aversion reflects the higher utility loss of a spending cut from a reference point than the utility gain from a similar spending increase, in the spirit of Prospect Theory's loss aversion. This paper posits a model of utility of spending scaled by a function of past peak spending, called target spending. The discontinuity of the marginal utility at the target spending corresponds to shortfall aversion. According to the closed-form solution of the associated spending-investment problem, (i) the spending rate is constant and equals the historical peak for relatively large values of wealth/target; and (ii) the spending rate increases (and the target with it) when that ratio reaches its model-determined upper bound. These features contrast with traditional Merton-style models which call for spending rates proportional to wealth. A simulation using the 1926-2012 realized returns suggests that spending of the very shortfall averse is typically increasing and very smooth.

Keywords: Loss aversion; Portfolio choice; Consumption; Endowments (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2014-07
New Economics Papers: this item is included in nep-upt
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Citations: View citations in EconPapers (1)

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