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Loss aversion with a state-dependent reference point

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  • Enrico G. De Giorgi

    ()

  • Thierry Post

    ()

Abstract

This 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 Info

Paper 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.

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Length: 45 pages
Date of creation: Jul 2010
Date of revision:
Handle: RePEc:usg:dp2010:2010-23

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Related research

Keywords: Reference-dependent preferences; stochastic reference point; loss aversion; disappointment theory; regret theory.;

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  1. Jonathan Shalev, 2000. "Loss aversion equilibrium," International Journal of Game Theory, Springer, vol. 29(2), pages 269-287.
  2. Sugden, Robert, 2003. "Reference-dependent subjective expected utility," Journal of Economic Theory, Elsevier, vol. 111(2), pages 172-191, August.
  3. Schmidt, Ulrich & Starmer, Chris & Sugden, Robert, 2008. "Third-generation prospect theory," Open Access Publications from Kiel Institute for the World Economy 28932, Kiel Institute for the World Economy (IfW).
  4. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  5. 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.
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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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