Asset Allocation with Disappointment Aversion

This paper investigates disappointment aversion (DA) in financial markets within a typical asset allocation framework. Drawing upon the seminal study of Ang et. al. (2005), we incorporate disappointment aversion (that is, aversion to outcomes that are worse than prior expectations) within a simple theoretical portfolio-choice model. Based on the results of this model, we then empirically address the portfolio allocation problem of an investor who chooses between a risky and a risk-free asset using international data from 19 countries [see Xie et al. (2013)]. Our findings strongly support the view that disappointment aversion leads investors to reduce their exposure to the stock market (i.e., disappointment aversion significantly depresses the weights to equities in all cases considered). Overall, it appears that disappointment aversion plays an important role in explaining the equity premium puzzle around the world.