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

Rengifo, Erick W. and Trifan, Emanuela (2007):
Investors Facing Risk: Loss Aversion and Wealth Allocation Between Risky and Risk-Free Assets.
Darmstadt, In: Darmstadt Discussion Papers in Economics, [Online-Edition: http://econstor.eu/bitstream/10419/32078/1/534881440.PDF],
[Report]

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.

Item Type: Report
Erschienen: 2007
Creators: Rengifo, Erick W. and Trifan, Emanuela
Title: Investors Facing Risk: Loss Aversion and Wealth Allocation Between Risky and Risk-Free Assets
Language: English
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.

Series Name: Darmstadt Discussion Papers in Economics
Volume: 180
Place of Publication: Darmstadt
Uncontrolled Keywords: prospect theory, loss aversion, capital allocation, Value-at-Risk, portfolio evaluation
Divisions: 01 Department of Law and Economics
01 Department of Law and Economics > Volkswirtschaftliche Fachgebiete
Date Deposited: 20 Nov 2008 08:25
Official URL: http://econstor.eu/bitstream/10419/32078/1/534881440.PDF
Additional Information:

JEL - Classification : C32, C35, G10

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