Stochastic Reference Points And The Dependence Structure

This study develops a framework for dealing with stochastic reference points and endogenously selecting the reference point in reference-dependent choice theories that accounts for the joint probability distribution of the prospects and the reference point. Without accounting for the dependence structure, the endogenous reference point can deviate from the decision-maker’s optimum. Accounting for dependence, reference dependence affects choice behavior only if the reference point is (in part or in whole) exogenously fixed. In an application to well-known US investment benchmark data, investors invest in riskless T-bills rather than stocks if we ignore the dependence structure, while investing in small value stocks is optimal when we account for dependence.