How Endogenization of the Reference Point Affects Loss Aversion: A Study of Portfolio Selection

Xue Dong He () and Moris S. Strub ()
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Xue Dong He: Department of Systems Engineering and Engineering Management, The Chinese University of Hong Kong, Shatin, New Territories, Hong Kong
Moris S. Strub: Department of Information Systems and Management Engineering, Southern University of Science and Technology, Shenzhen, Guangdong 518055, China; Institute of Risk Analysis, Prediction, and Management, Southern University of Science and Technology, Shenzhen, Guangdong 518055, China

Operations Research, 2022, vol. 70, issue 6, 3035-3053

Abstract: We study the implications of various models of partially endogenous reference point formation on optimal decision making in the context of portfolio optimization under loss aversion. Specifically, we first consider the partially endogenous model of De Giorgi and Post [ Management Science (2011) 57(6):1094–1110], where the reference point is determined in equilibrium but contains an exogenous component. We find that optimal trading behavior is as if the reference point were completely exogenous and that allowing for a mental adjustment of the reference point solely manifests itself in a lower degree of loss aversion. We then propose two novel models of partially endogenous reference point formation: A model of a reference point determined by optimal expectations and a model of mental reference point updating. Our conclusions on the effect of a partially endogenized reference point on portfolio selection under loss aversion are also confirmed under these two models. These findings suggest that it is difficult to separately identify an agent’s degree of loss aversion and his or her reference point and may help to explain why experienced and sophisticated agents appear to be less loss averse than expected in some field settings. Our models also predict that displays of loss aversion are decreasing in the duration an agent is given to contemplate a decision.

Keywords: Financial Engineering; gain-loss utility; reference point formation; loss aversion; portfolio optimization (search for similar items in EconPapers)
Date: 2022
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