Loss Aversion with a State-Dependent Reference Point

34 Pages Posted: 13 Apr 2007 Last revised: 17 Feb 2011

See all articles by Enrico G. De Giorgi

Enrico G. De Giorgi

University of St. Gallen - SEPS: Economics and Political Sciences

Thierry Post

Graduate School of Business of Nazarbayev University

Date Written: February 14, 2011

Abstract

This study investigates reference-dependent choice with a stochastic, state-dependent reference point. The optimal reference-dependent solution equals the optimal consumption solution (no loss aversion) if the reference point is selected fully endogenously. Given that loss aversion is widespread, we conclude that the reference point generally includes an important exogenously fixed component. We develop a choice model in which adjustment costs can cause stickiness relative to an initial, exogenous reference point. Using historical US investment benchmark data, we show that this model is consistent with diversification across bonds and stocks for a wide range of evaluation horizons, despite the historically high risk premium of stocks compared to bonds.

Keywords: behavioral finance, asset pricing, equity premium puzzle, reference-dependent preferences, loss aversion, stochastic reference point

JEL Classification: D81, G11, G12, C23

Suggested Citation

De Giorgi, Enrico G. and Post, Thierry, Loss Aversion with a State-Dependent Reference Point (February 14, 2011). Swiss Finance Institute Research Paper No. 07-14, Available at SSRN: https://ssrn.com/abstract=979854 or http://dx.doi.org/10.2139/ssrn.979854

Enrico G. De Giorgi (Contact Author)

University of St. Gallen - SEPS: Economics and Political Sciences ( email )

Department of Economics
Bodanstrasse 6
CH-9000 St. Gallen
Switzerland
+41712242430 (Phone)

Thierry Post

Graduate School of Business of Nazarbayev University ( email )

53 Kabanbay Batyra Avenue
Astana, 010000
Kazakhstan

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