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Loss Aversion with a State-Dependent Reference Point

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  • Enrico G. De Giorgi

    ()
    (School of Economics and Political Science, University of St. Gallen, 9000 St. Gallen, Switzerland)

  • Thierry Post

    ()
    (Graduate School of Business, Koç University, 34450 Istanbul-Sar{\i}yer, Turkey)

Abstract

This study investigates reference-dependent choice with a stochastic, state-dependent reference point. The optimal reference-dependent solution equals the optimal consumption solution (no loss aversion) if the reference point is selected fully endogenously. Given that loss aversion is widespread, we conclude that the reference point generally includes an important exogenously fixed component. We develop a choice model in which adjustment costs can cause stickiness relative to an initial, exogenous reference point. Using historical U.S. investment benchmark data, we show that this model is consistent with diversification across bonds and stocks for a wide range of evaluation horizons, despite the historically high-risk premium of stocks compared to bonds. This paper was accepted by Peter Wakker, decision analysis.

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File URL: http://dx.doi.org/10.1287/mnsc.1110.1338
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 57 (2011)
Issue (Month): 6 (June)
Pages: 1094-1110

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Handle: RePEc:inm:ormnsc:v:57:y:2011:i:6:p:1094-1110

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Related research

Keywords: behavioral finance; asset pricing; equity premium puzzle; reference-dependent preferences; loss aversion; stochastic reference point;

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  1. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  2. Jonathan Shalev, 1997. "Loss Aversion Equilibrium," Game Theory and Information 9703001, EconWPA, revised 11 Mar 1997.
  3. Christofides, Tasos C. & Vaggelatou, Eutichia, 2004. "A connection between supermodular ordering and positive/negative association," Journal of Multivariate Analysis, Elsevier, vol. 88(1), pages 138-151, January.
  4. Ulrich Schmidt & Chris Starmer & Robert Sugden, 2008. "Third-generation prospect theory," Journal of Risk and Uncertainty, Springer, vol. 36(3), pages 203-223, June.
  5. Sugden, Robert, 2003. "Reference-dependent subjective expected utility," Journal of Economic Theory, Elsevier, vol. 111(2), pages 172-191, August.
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Cited by:
  1. Graham Loomes & Shepley Orr & Robert Sugden, 2009. "Taste uncertainty and status quo effects in consumer choice," Journal of Risk and Uncertainty, Springer, vol. 39(2), pages 113-135, October.

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