Does Prospect Theory Explain the Disposition Effect?
AbstractThe 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 InfoPaper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 262.
Date of creation: Jan 2006
Date of revision:
Disposition effect; prospect theory; portfolio choice;
Find related papers by JEL classification:
- C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-01-24 (All new papers)
- NEP-FMK-2006-01-24 (Financial Markets)
- NEP-UPT-2006-01-24 (Utility Models & Prospect Theory)
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