Momentum Trading Through Reference Dependent Preferences

The endowment effect is a well-known behavioral regularity in which a person is less likely to trade a good when he is endowed with it. In their generalization of prospect theory to consumption bundles with multiple attributes, Tversky and Kahneman [1991] imply the endowment effect as a consequence of loss aversion and diminishing sensitivity in gains. It has since frequently been presumed that this form of reference dependent preferences will inhibit trade. However, in this paper it is demonstrated that loss aversion and diminishing sensitivity in gains also imply a dynamic momentum trading effect that increases exchange, so the net effect of such preferences on trading volume is ambiguous. In fact, the momentum trading effect is shown to completely cancel out the endowment effect in an important class of examples.