Behavioral Finance for Private Banking, 2nd Edition

CHAPTER 9Life‐Cycle Planning

So far, we have mainly dealt with investment situations, where the investors do not need to withdraw wealth for consumption before the ultimate investment result is revealed. If the investors want to make a long‐term plan (e.g., along their life‐cycle), then it is evident that the consumption and the investment decision must be integrated. Moreover, it is natural in life‐cycle planning to assume that the reference consumption level is updated over time. This leads to the effect of habit formation; that is, one gets used to a previously high consumption level. Finally, we will discuss how future consumption is discounted to present consumption. The rational way is exponential discounting—like taking compounded interest—while behavioral agents might discount the future against the presence even more, which is the concept of hyperbolic discounting. In addition to the previous chapter, we now have to consider an exogenous flow of wealth (human capital or labor income) that is hump‐shaped (highest in the middle period).

The following questions will be addressed from a rational (inter‐temporal expected discounted utility maximizer) and a behavioral (prospect theory maximizer with hyperbolic discounting adjusting the reference point over the life‐cycle) investor:

• What is the best consumption/savings path along the life cycle?
• What is the best proportion of risky assets to financial capital over the life cycle?
• Does it make sense to lock in the investor ...