Realization Utility with Reference-Dependent Preferences

TL;DR

This paper introduces a dynamic investment model incorporating reference-dependent, S-shaped preferences that explains investor behavior, including gains, losses, and market anomalies, through a tractable realization utility framework.

Contribution

It develops a novel, analytically manageable model of realization utility with reference dependence, capturing key empirical phenomena and market anomalies.

Findings

Predicts volume and size of realized gains and losses

Explains the disposition effect and holding period behaviors

Accounts for market anomalies like flattening of the capital market line

Abstract

We develop a tractable model of realization utility that studies the role of reference-dependent S-shaped preferences in a dynamic investment setting with reinvestment. Our model generates both voluntarily realized gains and losses. It makes specific predictions about the volume of gains and losses, the holding periods, and the sizes of both realized and paper gains and losses that can be calibrated to a variety of statistics, including the Odean measure of the disposition effect. Our model also predicts several anomalies including, among others, the flattening of the capital market line and a negative price for idiosyncratic risk.