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

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  • Rengifo, Erick W.
  • Trifan, Emanuela

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.

Suggested Citation

  • Rengifo, Erick W. & Trifan, Emanuela, 2006. "Investors Facing Risk: Loss Aversion and Wealth Allocation Between Risky and Risk-Free Assets," Darmstadt Discussion Papers in Economics 180, Darmstadt University of Technology, Department of Law and Economics.
    • Handle: RePEc:zbw:darddp:dar_28063
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    References listed on IDEAS

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    1. Rengifo, Erick W. & Trifan, Emanuela, 2007. "Investors Facing Risk II: Loss Aversion and Wealth Allocation When Utility Is Derived From Consumption and Narrowly Framed Financial Investments," Publications of Darmstadt Technical University, Institute for Business Studies (BWL) 28002, Darmstadt Technical University, Department of Business Administration, Economics and Law, Institute for Business Studies (BWL).
    2. Rengifo, Erick W. & Trifan, Emanuela, 2007. "Investors Facing Risk II: Loss Aversion and Wealth Allocation When Utility Is Derived From Consumption and Narrowly Framed Financial Investments," Darmstadt Discussion Papers in Economics 181, Darmstadt University of Technology, Department of Law and Economics.

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    More about this item

    Keywords

    prospect theory; loss aversion; capital allocation; Value-at-Risk; portfolio evaluation;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C35 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Discrete Regression and Qualitative Choice Models; Discrete Regressors; Proportions
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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