Failing to Foresee the Updating of the Reference Point Leads to Time-Inconsistent Investment
Operations Research · 2020 · Volume 68 · Issue 1
Abstract
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.
Keywords
decision analysis: applications, finance: portfolio, utility/preference: applications, Decision Analysis, reference-dependent preferences, reference point updating, time-inconsistency, stochastic control, portfolio selection, prediction bias
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