Shortfall aversion. (English) Zbl 07326771

Guasoni, Paolo; Huberman, Gur; Ren, Dan

Math. Finance 30, No. 3, 869-920 (2020).

Summary: Shortfall aversion reflects the higher utility loss of spending cuts from a reference than the utility gain from similar spending increases. Inspired by Prospect Theory’s loss aversion and the peak-end rule, this paper posits a model of utility from spending scaled by past peak spending. In contrast to traditional models, which call for spending rates proportional to wealth, the optimal policy in this model implies a constant spending rate equal to the historical peak when wealth is relatively large. The spending rate increases when wealth reaches a model-determined multiple of peak spending. In 1926–2015, shortfall-averse spending is smooth and typically increasing.

MSC:

91Gxx

Actuarial science and mathematical finance

Keywords:

consumption; endowments; portfolio choice; shortfall aversion