Dynamic Trading with Reference Point Adaptation and Loss Aversion

We formalize the reference point adaptation process by relating it to a way people perceive prior gains and losses. We then develop a dynamic trading model with reference point adaptation and loss aversion, and derive its semi‐analytical solution. The derived optimal stock holding has an asymmetric V‐shaped form with respect to prior outcomes, and the related sensitivities are directly determined by the sensitivities of reference point shifts with respect to the outcomes. We also find that the effects of reference point adaptation can be used to shed light on some well documented trading patterns, e.g., house money, break even, and disposition effects.