Optimal portfolio choice under loss aversion

Prospect theory and loss aversion play a dominant role in behavioral finance. In this paper we derive closed-form solutions for optimal portfolio choice under loss aversion. When confronted with gains a loss averse investor behaves similar to a portfolio insurer. When confronted with losses, the investor aims at maximizing the probability that terminal wealth exceeds his aspiration level. Our analysis indicates that a representative agent model with loss aversion cannot resolve the equity premium puzzle. We also extend the martingale methodology to allow for more general utility functions and provide a simple approach to incorporate skewed and fat-tailed return distributions.