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Does Prospect Theory Explain the Disposition Effect?

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Author Info
Hens, Thorsten () (Institute for Empirical Research in Economics, University of Zurich)
Vlcek, Martin () (Institute for Empirical Research in Economics, University of Zurich)
Abstract

The disposition effect is the observation that investors hold winning stocks too long and sell losing stocks too early. A standard explanation of the disposition effect refers to prospect theory and in particular to the asymmetric risk aversion according to which investors are risk averse when faced with gains and risk-seeking when faced with losses. We show that for reasonable parameter values the disposition effect can however not be explained by prospect theory as proposed by Kahneman and Tversky. The reason is that those investors who sell winning stocks and hold loosing assets would in the first place not have invested in stocks. That is to say the standard prospect theory argument is sound ex-post, assuming that the investment has taken place, but not ex-ante, requiring that the investment is made in the first place.

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Publisher Info
Paper provided by Department of Finance and Management Science, Norwegian School of Economics and Business Administration in its series Discussion Papers with number 2005/18.

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Length: 37 pages
Date of creation: 22 Dec 2005
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Handle: RePEc:hhs:nhhfms:2005_018

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Keywords: Disposition effect; prospect theory; portfolio choice;

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Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Francisco J. Gomes, 2005. "Portfolio Choice and Trading Volume with Loss-Averse Investors," Journal of Business, University of Chicago Press, vol. 78(2), pages 675-706, March. [Downloadable!]
  2. Grinblatt, Mark & Keloharju, Matti, 2000. "The investment behavior and performance of various investor types: a study of Finland's unique data set," Journal of Financial Economics, Elsevier, vol. 55(1), pages 43-67, January. [Downloadable!] (restricted)
  3. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  4. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October. [Downloadable!] (restricted)
  5. Arjan B. Berkelaar & Roy Kouwenberg & Thierry Post, 2004. "Optimal Portfolio Choice under Loss Aversion," The Review of Economics and Statistics, MIT Press, vol. 86(4), pages 973-987, 02. [Downloadable!] (restricted)
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  6. Weber, Martin & Camerer, Colin F., 1998. "The disposition effect in securities trading: an experimental analysis," Journal of Economic Behavior & Organization, Elsevier, vol. 33(2), pages 167-184, January. [Downloadable!] (restricted)
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Cited by:
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  1. Nicholas Barberis & Wei Xiong, 2006. "What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation," NBER Working Papers 12397, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Boolell-Gunesh S. & Broihanne M-H. & Merli M., 2008. "Are French Individual Investors reluctant to realize their losses?," Working Papers of LaRGE (Laboratoire de Recherche en Gestion et Economie) 2008-09, Laboratoire de Recherche en Gestion et Economie, Université de Strasbourg (France). [Downloadable!]
  3. Enrico Giorgi & Thorsten Hens, 2006. "Making prospect theory fit for finance," Financial Markets and Portfolio Management, Springer, vol. 20(3), pages 339-360, September. [Downloadable!] (restricted)
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