Journal
OPERATIONS RESEARCH
Volume 68, Issue 1, Pages 199-213Publisher
INFORMS
DOI: 10.1287/opre.2019.1872
Keywords
reference-dependent preferences; reference point updating; time-inconsistency; stochastic control; portfolio selection; prediction bias
Funding
- Research Grants Council of Hong Kong [14204514]
- Swiss Study Foundation
- Patrick Huen Wing Ming Chair Professorship of Systems Engineering and Engineering Management
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The current literature on behavioral portfolio optimization with reference point updating assumes that the decision maker foresees how the reference point will evolve and thus solves a time-consistent problem formulation. Empirical findings, however, suggest that decision makers often fail to foresee the updating of the reference point and consequently make time-inconsistent decisions. We analyze and compare the optimal investment strategies for a discrete time behavioral portfolio optimization problem with loss-aversion and time-varying reference points under both the time-consistent and time-inconsistent framework and for different updating rules for the reference point. There is only one framework predicting realistic investment behavior: the decision maker fails to foresee the updating of the reference point and thus faces a time-inconsistent problem, solves for a dynamically optimal strategy, and updates the reference point in a nonrecursive manner.
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