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Essays on Expectations-Based Reference-Dependent Consumption and Portfolio Choice


This dissertation studies the life-cycle consumption and portfolio-choice implications of a new preference specification called "expectations-based reference-dependent preferences" or "news utility." These preferences formalize the idea that news or changes in expectations about present and future consumption generate instantaneous utility, by which bad news hurts more than good news pleases. The preferences were developed by Koszegi and Rabin (2006, 2007, 2009) to discipline and broadly apply the insights of prospect theory and have since been shown to be consistent with evidence in various behavioral and micro domains. In this dissertation, I show that the preferences not only explain evidence in micro domains but also generate interesting predictions in classic finance and macro models.

In the first part, I incorporate the preferences into a fully dynamic and stochastic life-cycle model to offer a new explanation for three major consumption facts -- excess smoothness and sensitivity in consumption, a hump-shaped consumption profile, and a drop in consumption at retirement. This new explanation relies on believable intuitions that are reminiscent of the micro evidence that the preferences were developed to explain and may provide new foundations for prominent ideas in the macro consumption literature. More precisely, excess smoothness and sensitivity, two prevailing macro consumption puzzles, are explained by loss aversion, a robust experimental risk preference, which has been assumed to explain the most important phenomena in behavioral economics. To explain the other life-cycle phenomena, the preferences combine precautionary savings, which have been studied extensively in the standard consumption literature, and an expectations-based time inconsistency, which is reminiscent of hyperbolic discounting.

In the second part, I explore the quantitative asset-pricing implications of news utility in a canonical Lucas-tree model. I find that the preferences easily succeed in matching historical levels of the equity premium, its volatility, and the degree of predictability in returns. Moreover, I show that the preferences imply plausible risk attitudes towards small, medium, and large consumption and wealth gambles and thus make another step towards resolving the equity premium puzzle.

In the third part, I extend the news-utility life-cycle model to portfolio choice. Beyond explaining predominant questions in the literature, such as non-participation in the presence of labor income, portfolio shares, and wealth accumulation, I put special emphasis on the question of how often the investor should pay attention to his portfolio. To answer this question, I consider a model in which the investor has access to a brokerage account, which he may or may not look up, and a checking account to finance inattentive consumption. As bad news hurt more than good news pleases, news utility results in a first-order decrease in expected utility and the investor refuses to look up his portfolio and rebalance most of the time. If he looks it up, however, he rebalances extensively. Moreover, the investor is subject to a commitment problem. He would like to precommit to being inattentive even more often because he does not overconsume out of his checking account. Consequently, the investor gains from engaging in mental accounting and would be happy to pay for investment tools that encourage inattention and rebalance actively, such as delegated portfolio management.

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