N°26-23: Reference Points Driven Investors' Demand, Disposition Effect and Momentum in Stock Returns

This paper develops a market model to analyze portfolio decisions and asset pricing implications of cumulative prospect theory preferences (Kahneman and Tversky 1979; Tversky and Kahneman 1992) when the reference point is dynamic and stochastic. We show that in the proposed framework, an asymmetric adaptation of reference aspiration levels after gains and losses is a necessary condition to obtain the disposition effect. Moreover, the model implies that at equilibrium, the equity premium reflects investors' expectations about their future reference adjustment. We test whether the conditions on the reference-point dynamics that imply the disposition effect also help explain market characteristics such as momentum and short-term reversals. We provide empirical evidence that supporting this hypothesis.