Reference-Point Theory: An Account of Individual Differences in Risk Preferences

Abstract

We propose an account of individual differences in risk preferences called “reference-point theory” for choices between sure things and gambles. Like most descriptive theories of risky choice, preferences depend on two drivers—hedonic sensitivities to change and beliefs about risk. But unlike most theories, these drivers are estimated from judged feelings about choice options and gamble outcomes. Furthermore, the reference point is assumed to be the less risky option (i.e., sure thing). Loss aversion (greater impact of negative change than positive change) and pessimism (belief the worst outcome is likelier) predict risk aversion. Gain seeking (greater impact of positive change than negative change and optimism (belief the best outcome is likelier) predict risk seeking. But other combinations of hedonic sensitivities and beliefs are possible, and they also predict risk preferences. Finally, feelings about the reference point predict hedonic sensitivities. When decision makers feel good about the reference point, they are frequently loss averse. When they feel bad about it, they are often gain seeking. Three studies show that feelings about reference points, feelings about options and feelings about outcomes predict risky choice and help explain why individuals differ in their risk preferences.