Working Paper: CEPR ID: DP10064
Authors: Paolo Guasoni; Gur Huberman; Dan Ren
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.
Keywords: Consumption; Endowments; Loss Aversion; Portfolio Choice
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| shortfall aversion (D81) | greater utility loss from spending cuts (D11) |
| shortfall aversion (D81) | utility gain from equivalent spending increases (D11) |
| current spending to past peak spending ratio (E62) | marginal utility of spending (D11) |
| wealth approaches target (G11) | spending behavior transitions (D12) |
| spending behavior transitions (D12) | spending remains constant at target level (E63) |
| shortfall aversion (D81) | spending growth (E20) |