Shortfall aversion reflects the higher utility loss of a spending cut from a reference point than the utility gain from a similar spending increase, in the spirit of Prospect Theory's loss aversion. This paper posits a model of utility of spending scaled by a function of past peak spending, called target spending. The discontinuity of the marginal utility at the target spending corresponds to shortfall aversion. According to the closed-form solution of the associated spending-investment problem, (i) the spending rate is constant and equals the historical peak for relatively large values of wealth/target; and (ii) the spending rate increases (and the target with it) when that ratio reaches its model-determined upper bound. These features contrast with traditional Merton-style models which call for spending rates proportional to wealth. A simulation using the 1926-2012 realized returns suggests that spending of the very shortfall averse is typically increasing and very smooth.
Guasoni, Paolo, Gur Huberman, and Dan Ren. "Shortfall Aversion." Columbia Business School, February 2015.
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