Abstract
A large amount of literature in the field of social psychology and product pricing discusses the role of reference prices in affecting buyer’s price perception and purchase intention. Reference price denotes a standard against which the consumer compares the offer price of a product. In this paper, we investigate whether reference prices play any role in affecting the trading decision of stock market investors. We use firm-level, fixed-effect panel data methodology to empirically investigate whether investors respond to a violation of their internalized reference price range by executing a trading decision. Our results, based on a sample of Indian firms with small capitalization, show that investors respond to a violation of their internalized reference price range by executing a trading decision. However, consistent with the prior findings that investors suffer from myopic loss aversion, they continue to hold the positions when the reference price range is violated on the downside but sell stocks that have violated the high point of the reference price range. Our findings are robust for the reference price ranges that are constructed using the prior day’s trading prices, prior week’s trading prices, and prior year’s trading prices. The portfolio managers can develop a better understanding of expected trading intensity by incorporating reference price range in their models. The policymakers can use our results to find ways to improve the liquidity and efficiency of financial markets.
Highlights
A large amount of literature in the field of social psychology and product pricing discusses the role of reference prices in affecting buyer’s price perception and purchase intention
The daily turnover, defined as ratio of shares traded to the total shares outstanding for the company, is less than 1% for small capitalization stocks
The investors should respond to a violation of their internalized reference price range by executing a trading decision
Summary
A large amount of literature in the field of social psychology and product pricing discusses the role of reference prices in affecting buyer’s price perception and purchase intention. In the spirit of Thaler (1983), we focus on the investor’s perception of transaction utility rather than acquisition utility To this effect, we study the relationship between the reference price and trading volumes rather than focusing on stock returns that bear no relationship with immediate purchase intention. The disposition effect documents an investor bias where investors realize gains by Such characteristics emanate from investor’s naïve presumption that low priced stocks entail limited losses (worst case being stock price going down from a low value to zero) and the probability of very high gains. This mental simplification ignores the fact that total investment is the relevant metric to evaluate “value at risk” and not the nominal share price.
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