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

Abstract

We study the implications of various models of reference point formation on optimal decision making in the context of portfolio optimization under loss aversion. If the reference point is exogenously given, then the predictions of any such model crucially depend on the choice of the reference point. On the other hand, if the reference point were fully endogenously determined, then loss aversion would not affect choice behavior, which is in violation of the empirical evidence. We thus consider the partially endogenous model of De Giorgi and Post [Management Science 57 (6):1094--1110, 2011], 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 reference point formation: A model of a mentally optimal reference point and a model of mental reference point updating. Our conclusions on the effect of an endogenized reference point on portfolio selection under loss aversion are also confirmed under these two models.

Keywords: gain-loss utility; reference point formation, loss aversion, portfolio optimization

JEL Classification: G02, G11