Chris Riley,previously a Postgraduate Researcher at the University of Leeds, working with Barbara Summers and Darren Duxbury (Newcastle University Business School), has had his research on reference points published in Management Science. Chris’s work in this area won a graduation prize for Outstanding Academic Achievement. He is now a Lecturer at the University of Leicester. The citation for the paper, links to the full text and abstract are below. You can also read our blog on the paper here.
Financial models incorporating a reference point, such as the Capital Gains Overhang (CGO) model, typically assume it is fixed at the purchase price. Combining experimental and market data, this paper examines whether such models can be improved by incorporating reference-point adjustment. Using real stock prices over horizons from 6 months to 5 years, experimental evidence demonstrates that a number of salient points in the prior share price path are key determinants of the reference point, in addition to the purchase price. Market data testing is then undertaken by using the CGO model. We show that composite CGO variables, created by using a mix of salient points with weights determined in the experiment, have greater predictive power than the traditional CGO variable in both cross-sectional U.S. equity-return analysis and when analyzing the performance of double-sorted portfolios. In addition, future trading volume is more sensitive to changes in the composite CGO variables than to the traditional CGO, further emphasizing the importance of adjusting reference points.