Reference point

The reference point is an important element of the value function in Kahneman and Tversky's prospect theory. Taking value as a function of wealth, the Kahneman-Tversky value function is upward sloping everywhere, but with an abrupt decline in slope at the reference point. For wealth levels above the reference point, the value function is concave downward, just as are conventional utility functions. At the reference point, the value function may be regarded, from the fact that its slope changes abruptly there, as infititely concave downward. For wealth levels below the reference point, Kahneman and Tversky found evidence that the value function is concave upward (Shiller, 1997).

As a consequence of such a functional form, the risk attitude of decision makers will depend on whether they are in a win or a loss situation relative to their reference point. People become risk lovers in loss situations and risk averters in win situations.

In behavioral finance this kind of value function is utilized to explain the so called disposition effect: the phenomenon that investors are reluctant to realize their losses but sell winners too early.

See also: behavioral finance risk attitude, risk aversion, utility

Literature: Kahneman & Tversky (1979), Kahneman & Tversky (1982), Odean (1997), Shiller (1997), Shefrin & Statman (1985), Tversky & Kahneman (1992)

Entry by: Andreas Laschke

November 17, 1997 Direct questions and comments to: Glossary master