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

37 Pages Posted: 20 Jan 2019 Last revised: 9 Jun 2020

See all articles by Xue Dong He

Xue Dong He

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

Moris Simon Strub

Southern University of Science and Technology - Division of Information Systems and Management Engineering

Date Written: January 18, 2019

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

Suggested Citation

He, Xue Dong and Strub, Moris Simon, How Endogenization of the Reference Point Affects Loss Aversion: A Study of Portfolio Selection (January 18, 2019). Available at SSRN: https://ssrn.com/abstract=3318295 or http://dx.doi.org/10.2139/ssrn.3318295

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

Moris Simon Strub

Southern University of Science and Technology - Division of Information Systems and Management Engineering ( email )

1088 Xueyuan Ave
Shenzhen, Guangdong
China

HOME PAGE: http://sites.google.com/view/morisstrub/home

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