Reference point Michel Pireu     | Business Day Thursday, January 31, 2019
Daniel Kahneman and Amos Tversky’s research in psychology and economics include breakthroughs in Prospect Theory and its constituents - cognitive frames of gain versus loss and the idea of the reference point.

“The reference point anchors our expectations and its dynamic nature is key to understanding market psychology,” says Richard Peterson CEO of MarketPsych, a training and sentiment analytics firm. “If we expect market prices to rise from the current point, we are operating from the frame of losses (we are down relative to where we want to be). In the frame of losses people take excessive risk. Investors who have a reference point for market prices above the current level will be more inclined to buy (or at least not to sell) during downturns. Over the past decade investors have learned that buying on dips is a successful approach, but that enthusiasm to ‘catch the falling knife’ is worrisome. It indicates that investors’ reference point is higher than current level. Selloffs usually don’t end until the reference point falls and short term investors wash out.”

During a bear market, investors gradually transition their reference points (expectations) from higher to lower. We will know we’re at a bottom when investors start selling “just to keep what I’ve got left” - that is, when their reference point falls to below the current level and their paper losses actually feel like gains because they are getting out with some cash (versus none).

However, sentiment can hit a low along with prices, bounce for a week or two (as we’ve seen), and then rollover to hit lower lows. Reference points (expectations) are dynamic, and they are contingent upon emotional state and stress level. This is a key to understanding and using Prospect Theory in financial markets - reference points change.

Media sentiment reflects these shifts.
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