Optimal portfolio choice with loss aversion over consumption

This paper analyses the consumption-investment problem of a loss averse investor with an s-shaped utility over consumption relative to a time-varying reference level. Optimal consumption exceeds the reference level in good times and descends to the subsistence level in bad times. Accordingly, the optimal portfolio is dominated by a mean-variance component in good times and rebalanced more aggressively toward stocks in bad times. This consumption-investment strategy contrasts with customary portfolio theory and is consistent with several recent stylized facts about investor' behavior. I also analyze the joint effect of loss aversion and persistence of the reference level on optimal choices. Finally, the strategy of the loss-averse investor outperforms the conventional Merton-style strategies in bad times, but tends to be dominated by the conventional strategies in good times.