DP10064 Shortfall Aversion

Author(s): Paolo Guasoni, Gur Huberman, Dan Ren
Publication Date: July 2014
Keyword(s): consumption, endowments, loss aversion, portfolio choice
JEL(s): G11, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10064

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.