Loss Aversion with a State-Dependent Reference Point

Management Science · 2011 · Volume 57 · Issue 6

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.

Keywords

behavioral finance, asset pricing, equity premium puzzle, reference-dependent preferences, loss aversion, stochastic reference point

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