EITM: Collaborative Research: Reference Point Adaptation and Mental Accounting -- Dynamic Extensions of Prospect Theory

Under prospect theory, a person's satisfaction derived from a gain or loss is calculated as a deviation from that person's status quo wealth reference point. However over time each gain or loss has the potential to alter the reference point as the individual adapts to the change in wealth. Our pilot data suggest that people adapt their reference points more readily to gains than to losses. The quicker adaptation to gains leads to immediate gratification from mentally assimilating those gains, but dissatisfaction with subsequent gains, which feel less impressive relative to the new, elevated reference point. The slower adaptation to losses reduces immediate misery by deferring the assimilation of the new, lower wealth level, but also decreases the satisfaction associated with future gains or losses. Our proposal is designed to investigate individuals' readiness to adapt to gains versus losses, the factors that influence adaptation, and the means by which adaptation occurs. Questionnaires and a new experimental auction design with real monetary payoffs will be used to identify the location of reference points and their movements after gains or losses. We will also continue research we have already begun in which we have tested our predictions about reference point adaptation using actual trading data from United States brokerage houses. Researchers have recently discovered that some anomalous price patterns are present in American financial markets are absent in Asian markets, and conversely. Also, risk preferences and styles of information processing have been shown to differ in Asian and Western cultures. In addition to collecting data in the United States, we will perform experiments in Korea and China to explore whether cultural differences influence reference point adaptation, which in turn may contribute to differences across countries in the behavior of stock returns.