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We explicitly derive and explore the optimal consumption and portfolio policies of a loss-averse individual who endogenously updates his or her reference level over time. We find that the individual protects current consumption by delaying painful reductions in consumption after a drop in wealth, and increasingly so with higher degrees of endogeneity. The incentive to protect current consumption is stronger with a medium wealth level than with a high or low wealth level. Furthermore, this individual adopts a conservative investment strategy in normal states and typically a more aggressive strategy in good and bad states. Endogeneity of the reference level increases overall risk-taking and generates an incentive to reduce risk exposure with age even without human capital. The welfare loss that this individual would suffer under the conventional constant relative risk aversion (CRRA) consumption and portfolio policies easily exceeds 10%. This paper was accepted by Tyler Shumway, finance.

This paper explicitly derives the optimal dynamic consumption and portfolio choice of an individual with prospect theory preferences. The individual is loss averse, endogenously updates his reference level over time, and distorts probabilities. We show that the optimal consumption strategy is rather insensitive to economic shocks. In particular, in case the individual sufficiently overweights unlikely unfavorable events, our model generates an endogenous floor on consumption. As a result, an individual with prospect theory preferences typically implements a (very) conservative portfolio strategy. We discuss implications of our results for the design of investment-linked annuity products.

The standard expected utility model of tax evasion predicts that evasion is decreasing in the marginal tax rate (the Yitzhaki puzzle). The existing literature disagrees on whether prospect theory overturns the puzzle. We disentangle four distinct elements of prospect theory and find loss aversion and probability weighting to be redundant in respect of the puzzle. Prospect theory fails to reverse the puzzle for various classes of endogenous specification of the reference level. These classes include, as special cases, the most common specifications in the literature. New specifications of the reference level are needed, we conclude.