Realization Utility with Adaptive Reference Points

41 Pages Posted: 12 Aug 2015 Last revised: 7 Dec 2017

See all articles by Xue Dong He

Xue Dong He

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management

Linan Yang

Columbia University - Department of Industrial Engineering and Operations Research (IEOR)

Multiple version iconThere are 2 versions of this paper

Date Written: December 7, 2017

Abstract

Experimental studies have demonstrated that a typical investor derives utility of the gain and loss, relative to certain reference point, realized at each sale of a stock, and that the reference point adapts asymmetrically to the stock's prior gains and losses in that the adaptation to a gain is more substantial than to a comparable loss. This empirical finding motivates us to consider a dynamic trading problem in which an agent decides when to sequentially sell and buy a stock in order to maximize her utility of terminal wealth and realized gains and losses based on a reference point that adapts asymmetrically to the stock's prior gains and losses. We show that this agent is more reluctant to sell the stock at a loss than another agent whose reference point does not adapt to the stock gain or loss at all, leading to a higher percentage of gains realized (PGR) and a lower percentage of losses realized (PLR). We also show that when the agent weighs the utility of realized gains and losses more heavily in her investment criteria, she trades the stock more frequently, the PGR becomes lower, and the PLR becomes higher.

Keywords: realization utility, reference point adaptation, wealth utility, cumulative prospect theory, optimal stopping

JEL Classification: D03, G11, G12

Suggested Citation

He, Xue Dong and Yang, Linan, Realization Utility with Adaptive Reference Points (December 7, 2017). Available at SSRN: https://ssrn.com/abstract=2642276 or http://dx.doi.org/10.2139/ssrn.2642276

Xue Dong He (Contact Author)

The Chinese University of Hong Kong - Department of Systems Engineering and Engineering Management ( email )

505 William M.W. Mong Engineering Building
The Chinese University of Hong Kong, Shatin, N.T.
Hong Kong
Hong Kong

HOME PAGE: http://https://sites.google.com/site/xuedonghepage/home

Linan Yang

Columbia University - Department of Industrial Engineering and Operations Research (IEOR) ( email )

323 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

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