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Loss Aversion with a State-Dependent Reference Point

  • 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)

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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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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  1. SHALEV, Jonathan, 1997. "Loss aversion equilibrium," CORE Discussion Papers 1997023, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  2. Sugden, Robert, 2003. "Reference-dependent subjective expected utility," Journal of Economic Theory, Elsevier, vol. 111(2), pages 172-191, August.
  3. Ulrich Schmidt & Chris Starmer & Robert Sugden, 2008. "Third-generation prospect theory," Journal of Risk and Uncertainty, Springer, vol. 36(3), pages 203-223, June.
  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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