Loss aversion with a state-dependent reference point
AbstractThis study investigates loss aversion when the reference point is a state-dependent random variable. This case describes, for example, a money manager being evaluated relative to a risky benchmark index rather than a fixed target return level. Using a state-dependent structure, prospects are more (less) attractive if they depend positively (negatively) on the reference point. In addition, the structure avoids an inherent aversion to risky prospects and yields no losses when the prospect and the reference point are the same. Related to this, the optimal reference-dependent solution equals the optimal consumption solution (no loss aversion) when the reference point is selected completely endogenously. Given that loss aversion is widespread, we conclude that the reference point generally includes an important exogenously fixed component. For example, the typical investment benchmark index is externally fixed by the investment principal for the duration of the investment mandate. We develop a choice model where adjustment costs cause stickiness relative to an initial exogenous reference point.
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Bibliographic InfoPaper provided by Department of Economics, University of St. Gallen in its series University of St. Gallen Department of Economics working paper series 2010 with number 2010-23.
Length: 45 pages
Date of creation: Jul 2010
Date of revision:
Reference-dependent preferences; stochastic reference point; loss aversion; disappointment theory; regret theory.;
Other versions of this item:
- Enrico G. De Giorgi & Thierry Post, 2011. "Loss Aversion with a State-Dependent Reference Point," Management Science, INFORMS, vol. 57(6), pages 1094-1110, June.
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
- C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
- C93 - Mathematical and Quantitative Methods - - Design of Experiments - - - Field Experiments
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-07-24 (All new papers)
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