Reference Point Adaptation: Tests in the Domain of Security Trading

Abstract:     
According to prospect theory (Kahneman & Tversky, 1979), gains and losses are measured from a reference point. We attempted to ascertain to what extent the reference point shifts following gains or losses. In questionnaire studies we asked subjects what stock price today will generate the same utility as a previous change in a stock price. From participants' responses we calculated the magnitude of reference point adaptation, which was significantly greater following a gain than following a loss of equivalent size. We also found the asymmetric adaptation of gains and losses persisted when a stock was included within a portfolio rather than being considered individually. In studies using financial incentives within the Becker, DeGroot, and Marschak (1964) procedure, we again noted faster adaptation of the reference point to gains than losses. We related our findings to several aspects of asset pricing and investor behavior.

Keywords: Prospect theory, Reference point, Asset pricing, Security trading

JEL Classifications: C91, D81

Accepted Paper Series