Close Encounters of Two Kinds: False Alarms and Dashed Hopes

Abstract

People are frequently exposed to potentially attractive events that are subsequently and unexpectedly reversed and to potentially painful events, which are also unexpectedly reversed. In the process of being returned to the initial asset position, does the sequence in which the positive and negative events occur matter? This issue of the combined effect of pleasurable and painful stimuli has received scant theoretical or empirical attention. We attempt to fill this lacuna in the literature by studying the retrospective evaluation of surprises that return individuals to their original economic state. Although such surprises do not change an individual's original economic state, we argue that the individual's psychological state changes, and the final affective state is, among other things, a function of the sequence in which the events occur. From a theoretical standpoint, several perspectives can be brought to bear on the issue. For instance, one reading of mental accounting, based on prospect theory's value function, would predict that losses should dominate gains, and therefore, regardless of sequence, people should be unhappy when exposed to two economically equivalent outcomes of different signs. Conversely, the literature on intertemporal choice would suggest that a series that ends on an up note is preferred to a series that ends on a down note, because people like to defer gratification so that they may savor positive outcomes. Similarly, people apparently have a preference for "happy endings." Finally, the extant literature on "recency effects" would predict that the last event in a series should have a disproportionate influence on overall affect. Our model relies on a shift in the reference point to explain how a surprising reversal of an event will lead to a nonzero evaluation of the sequence. We suggest that people's reference points shift immediately but imperfectly after a stimulus is presented. Intuitively, this implies that the first stimulus will shift the reference point in its direction, as a result of which the evaluation of a sequence of events in which an initial event is unexpectedly reversed will be more favorable if the first event is a loss than if it is a gain. This model captures the unanticipated nature of the second event (i.e., the surprise element) by allowing the first event to move the reference point. Consequently, by the time the next event occurs the reference point has been updated, as a result of which the zero economic outcome of the sequence yields nonzero utility. We further posit that the magnitude of the reference point shift should be affected by the time elapsed between the two stimuli. Specifically, the reference point shifts gradually with time, until it is fully updated. Consequently, the final affective state of the sequence is also a function of the temporal distance between the two events. The main predictions of the model were empirically supported first in a survey using a mall-intercept sample. Subsequently, we conducted a study of student subjects involving ...

A cross-cultural study of reference point adaptation: Evidence from China, Korea, and the US

“…There are a very few studies testing the dynamic aspects of prospect theory using US subjects. Chen and Rao (2002) found that the order in which two opposite events (gain/loss) occurred affected the subject's final affective state, suggesting that a shift in the reference point occurred after the first event. Gneezy (2005) assumed that subjects are most willing to sell when the current price is equal to the reference point, and showed that assuming a stock's peak price to be the reference point best explained subjects' willingness to sell that stock.…”

Reference point adaptation: Tests in the domain of security trading

“…Investors may eventually update their reference points to the current price or partially update to a price between the initial price and the current price. Chen and Rao (2002) suggest that people's reference points shift after a stimulus is presented, but do so incompletely. However Chen and Rao (2002) only examined situations in which two outcomes occur with one being positive and the other being negative.…”

“…Chen and Rao (2002) suggest that people's reference points shift after a stimulus is presented, but do so incompletely. However Chen and Rao (2002) only examined situations in which two outcomes occur with one being positive and the other being negative. Gneezy (2002) inferred reference point adaptation from participants' decisions to sell their stocks when stock prices followed a random walk.…”

Loss Aversion and Residential Property Development Decisions in China: A Semi-Parametric Estimation

“…In addition, the adaptation of reference point is a huge issue. As Chen and Rao (2002) highlighted in their experiments, although people's reference points shift immediately after a stimulus occurs, such a shift is incomplete. The magnitude of the shift depends on the time difference between two stimuli.…”