How Investors Face Financial Risk: Loss Aversion and Wealth Allocation

Abstract

We studied how the capital allocation decisions and the loss version of nonprofessional investors change subject to behavioral factors. The optimal wealth allocation between risky and risk-free assets results within a value-at-risk (VaR) portfolio model, which involves assessing risk individually according to an extended prospect-theory framework. We showed how the past performance and the portfolio evaluation frequency affect investor behavior and prove myopic loss aversion holds across different evaluation frequencies. We also illustrated that 1 year is the optimal evaluation horizon at which, under practical constraints, maximization of risky holdings occurs. Finally, we presented evidence that indicates that researchers using standard VaR significance levels may be underestimating the loss aversion of individual investors.