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Loss aversion with a state-dependent reference point

Enrico De Giorgi () and Thierry Post ()

University of St. Gallen Department of Economics working paper series 2010 from Department of Economics, University of St. Gallen

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.

Keywords: Reference-dependent preferences; stochastic reference point; loss aversion; disappointment theory; regret theory. (search for similar items in EconPapers)
JEL-codes: D81 C23 C91 C93 (search for similar items in EconPapers)
Pages: 45 pages
Date: 2010-07
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http://ux-tauri.unisg.ch/RePEc/usg/dp2010/DP-1023-Gi.pdf (application/pdf)

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Journal Article: Loss Aversion with a State-Dependent Reference Point (2011) Downloads
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