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Does Prospect Theory Explain the Disposition Effect?

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  • Thorsten Hens
  • Martin Vlcek
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    Abstract

    The disposition e ect 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 rst 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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    Bibliographic Info

    Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 262.

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    Date of creation: Jan 2006
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    Handle: RePEc:zur:iewwpx:262

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    Keywords: Disposition effect; prospect theory; portfolio choice;

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    1. 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, Elsevier, vol. 55(1), pages 43-67, January.
    2. Francisco J. Gomes, 2005. "Portfolio Choice and Trading Volume with Loss-Averse Investors," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 78(2), pages 675-706, March.
    3. Chip Heath & Steven Huddart & Mark Lang, 1999. "Psychological Factors And Stock Option Exercise," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 114(2), pages 601-627, May.
    4. Shefrin, Hersh & Statman, Meir, 1985. " The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence," Journal of Finance, American Finance Association, American Finance Association, vol. 40(3), pages 777-90, July.
    5. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, Econometric Society, vol. 47(2), pages 263-91, March.
    6. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, Springer, vol. 5(4), pages 297-323, October.
    7. 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, November.
    8. Richard H. Thaler & Eric J. Johnson, 1990. "Gambling with the House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice," Management Science, INFORMS, INFORMS, vol. 36(6), pages 643-660, June.
    9. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, American Finance Association, vol. 53(5), pages 1775-1798, October.
    10. Weber, Martin & Camerer, Colin F., 1998. "The disposition effect in securities trading: an experimental analysis," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 33(2), pages 167-184, January.
    11. Kyle, Albert S. & Ou-Yang, Hui & Xiong, Wei, 2006. "Prospect theory and liquidation decisions," Journal of Economic Theory, Elsevier, Elsevier, vol. 129(1), pages 273-288, July.
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    Cited by:
    1. Menkhoff, Lukas & Nikiforow, Marina, 2009. "Professionals' endorsement of behavioral finance: Does it impact their perception of markets and themselves?," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 71(2), pages 318-329, August.

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