Disappointment Aversion and Income Risk: Implications for Portfolio Allocation

Abstract

I solve the life-cycle portfolio allocation problem of a disappointing averse (DA) agent. Unlike expected utility investors, the risky allocations relate positively with income risk over later phase of DA investor’s working life. The changing comovement between returns and disappointment/elation realization drives the effect. The heterogeneous Epstein-Zin model with disappointment aversion generates conditional portfolio shares that are a better match to the empirical pattern. Sufficiently disappointment-averse agents abstain from investing in stocks after retirement and the decline in income risk also drives stock allocations lower in the later phase of DA investor’s working life.