Portfolio choice with narrow framing and loss aversion: a simplified approach

Abstract

This paper considers portfolio construction issues for a ‘mental accountant’, who exhibits an S-shaped utility function with loss aversion and narrowly-frames their asset allocation decision. We argue that the presence of narrow framing does not circumvent the existence of a budget constraint, and explicitly incorporate this into the investor's portfolio selection problem. The assumption of narrow framing allows us to derive relatively simple expressions for the mental accountant's optimal asset allocation decision. Our findings indicate that the mental accountant operates similarly to a high-conviction investor, leading to a time-series momentum approach to investment.