741 - Shortfall Allowed: Loss Aversion and Habit Formation

Wetenschappelijke publicatie
Date 1 September 2003

In this paper we analyze a model of consumption and investment when preferences are loss averse around a habit level and investment yields an uncertain return. Loss aversion is the most natural way of modeling the presence of a habit as it explicitly models aversion to below-habit consumption. Existing approaches either neglect the possibility of below-habit consumption or model habit formation by dividing consumption through a habit. Confronting the traditional model using ratios with the outcome under loss aversion shows that the loss averse model yields a more natural interpretation thus appears more realistic. Starting with an analytical solution for a piecewise-linear utility function, the results are found to be robust for the more general Kahneman-Tversky formulation of the value function. Keywords: habit formation, loss aversion, consumption and investment, uncertainty, behavioral value function JEL Codes: D1, D8, D9, E2