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Dynamic Trading with Reference Point Adaptation and Loss Aversion

Author

Listed:
  • Yun Shi

    (School of Management, Shanghai University, Shanghai, China)

  • Xiangyu Cui

    (School of Statistics and Management, Shanghai University of Finance and Economics, Shanghai, China)

  • Jing Yao

    (Institute for Financial Studies, School of Economics, Fudan University, Shanghai, China)

  • Duan Li

    (Department of Systems Engineering and Engineering Management, The Chinese University of Hong Kong, Shatin N. T., Hong Kong)

Abstract

We formalize the reference point adaptation process by relating it to a way people perceive prior gains and losses. We then develop a dynamic trading model with reference point adaptation and loss aversion, and derive its semi-analytical solution. The derived optimal stock holding has an asymmetric V-shaped form with respect to prior outcomes, and the related sensitivities are directly determined by the sensitivities of reference point shifts with respect to the outcomes. We also find that the effects of reference point adaptation can be used to shed light on some well documented trading patterns, e.g., house money, break even, and disposition effects.

Suggested Citation

  • Yun Shi & Xiangyu Cui & Jing Yao & Duan Li, 2015. "Dynamic Trading with Reference Point Adaptation and Loss Aversion," Operations Research, INFORMS, vol. 63(4), pages 789-806, August.
    • Handle: RePEc:inm:oropre:v:63:y:2015:i:4:p:789-806
    DOI: 10.1287/opre.2015.1399
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    References listed on IDEAS

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    Cited by:

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    2. Guo, Jing & He, Xue Dong, 2017. "Equilibrium asset pricing with Epstein-Zin and loss-averse investors," Journal of Economic Dynamics and Control, Elsevier, vol. 76(C), pages 86-108.
    3. Gao, Jianjun & Li, Duan & Xie, Jinyan & Yang, Yiwen & Yao, Jing, 2024. "When Prospect Theory Meets Mean-Reverting Asset Returns: A Behavioral Dynamic Trading Model," Journal of Banking & Finance, Elsevier, vol. 162(C).
    4. Wang, Ruopeng & Wang, Jinting, 2018. "Procurement strategies with quantity-oriented reference point and loss aversion," Omega, Elsevier, vol. 80(C), pages 1-11.
    5. Gao, Jianjun & Li, Yaoming & Shi, Yun & Xie, Jinyan, 2024. "Multi-period portfolio choice under loss aversion with dynamic reference point in serially correlated market," Omega, Elsevier, vol. 127(C).
    6. Lou, Youcheng & Strub, Moris S. & Li, Duan & Wang, Shouyang, 2021. "The impact of a reference point determined by social comparison on wealth growth and inequality," Journal of Economic Dynamics and Control, Elsevier, vol. 127(C).
    7. Huijun Sun & Si Zhang & Linghui Han & Xiaomei Zhao & Lu Lou, 2020. "Day-to-Day Evolution Model Based on Dynamic Reference Point with Heterogeneous Travelers," Networks and Spatial Economics, Springer, vol. 20(4), pages 935-961, December.
    8. Philipp M. Möller, 2018. "Drawdown Measures And Return Moments," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 21(07), pages 1-42, November.
    9. Chen, Zengjing & Epstein, Larry G. & Zhang, Guodong, 2023. "A central limit theorem, loss aversion and multi-armed bandits," Journal of Economic Theory, Elsevier, vol. 209(C).
    10. Wen-Juan Xu & Chen-Yang Zhong & Fei Ren & Tian Qiu & Rong-Da Chen & Yun-Xin He & Li-Xin Zhong, 2020. "Evolutionary dynamics in financial markets with heterogeneities in strategies and risk tolerance," Papers 2010.08962, arXiv.org.
    11. Wen-Juan Xu & Li-Xin Zhong, 2022. "Market impact shapes competitive advantage of investment strategies in financial markets," PLOS ONE, Public Library of Science, vol. 17(2), pages 1-23, February.
    12. Jin, Xiu & Chen, Na & Yuan, Ying, 2019. "Multi-period and tri-objective uncertain portfolio selection model: A behavioral approach," The North American Journal of Economics and Finance, Elsevier, vol. 47(C), pages 492-504.
    13. Xiangyu Cui & Xun Li & Duan Li & Yun Shi, 2017. "Time consistent behavioral portfolio policy for dynamic mean–variance formulation," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 68(12), pages 1647-1660, December.
    14. Guo, Feiyu & Cao, Erbao, 2021. "Can reference points explain vaccine hesitancy? A new perspective on their formation and updating," Omega, Elsevier, vol. 99(C).
    15. Shi, Yun & Cui, Xiangyu & Li, Duan, 2015. "Discrete-time behavioral portfolio selection under cumulative prospect theory," Journal of Economic Dynamics and Control, Elsevier, vol. 61(C), pages 283-302.

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