Citation

Discussion Paper Details

Please find the details for DP10064 in an easy to copy and paste format below:

Full Details   |   Bibliographic Reference

Full Details

Title: Shortfall Aversion

Author(s): Paolo Guasoni, Gur Huberman and Dan Ren

Publication Date: July 2014

Keyword(s): consumption, endowments, loss aversion and portfolio choice

Programme Area(s): Financial Economics

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.

For full details and related downloads, please visit: https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10064

Bibliographic Reference

Guasoni, P, Huberman, G and Ren, D. 2014. 'Shortfall Aversion'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=10064