Roman Naryshkin

Portfolio Optimization: Habit Formation and Transaction Costs Roman Naryshkin

In traditional portfolio optimization/consumption literature individuals are assumed to be utility maximizing agents who make their investment and consumption decisions either by a rational application of mathematical and statistical principles or as if they were doing so. However, in recent years much evidence has been accumulating that individuals make decisions for different reasons. One approach that provides a better description of behavioral decision making aspects is to allow for consumption history dependent utility functions, so called "habit formation". This allows the resolution of several consumption-investment paradoxes including the "Equity Premium Puzzle" and the "Easterling Paradox" and can result in quantitative predictions of consumer behavior. However, another feature of financial markets, their transaction costs, suggests that even standard Merton consumption-investment agents will alter their decisions in many of the same ways as habit forming agents. The current book contains a thorough analysis of these two effects and provides a framework to enable their separation. The analysis should be useful to professionals in the field of Behavioral Finance.