Management Science, Volume 66, Issue 10 (October 2020)
Abstract: Financial models incorporating a reference point, such as the Capital Gains Overhang (CGO) model, typically assume it is fixed at the purchase price. Combining experimental and market data, this paper examines whether such models can be improved by incorporating reference point adjustment. Using real stock prices over horizons from 6-months to 5-years, experimental evidence demonstrates that a number of salient points in the prior share price path are key determinants of the reference point, in addition to the purchase price. Market data testing is then undertaken using the CGO model. We show that composite CGO variables, created using a mix of salient points with weights determined in the experiment, have greater predictive power than the traditional CGO variable in both cross-sectional US equity return analysis and when analyzing the performance of double-sorted portfolios. In addition, future trading volume is more sensitive to changes in the composite CGO variables than to the traditional CGO, further emphasizing the importance of adjusting reference points.
Dataset from the experiment (coming soon)
Abstract: While investor reference points play an important role in behavioral finance models, defining the boundary between gain and loss, it remains unclear how they adjust over sequential months across long investment horizons. In an experiment with US investors, we collect endogenous reference points monthly over a 60-month horizon to measure reference point adjustment. We then test our derived formula for sequential reference points using the Prospect Theory Value of a Stock Model, with market data testing confirming improved power to predict future US equity returns in both cross-sectional regressions and decile sorted portfolios. The results support the use of endogenous reference points in models that use sequential reference points.
Abstract: Drawing on insights from reference point adaptation, we decompose unrealized returns into adapted and unadapted components, with disparate implications for risk-taking following prior outcomes. We call the portion of the unrealized return that investors adjust to the adapted return, with the remaining part defined as the unadapted return. The reference point determines the decomposition as it adjusts from the purchase price. We show that adapted and unadapted returns influence future returns in opposing directions. The best-performing stocks are those with a low return in the distant past (adapted loss), but a high return in the recent past (unadapted gain).
New Project: Subjective Well Being, Hedonic Adjustment, and Reference Points (with B Summers)