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Probability weighting, stop-loss and the disposition effect

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  • Henderson, Vicky
  • Hobson, David
  • Tse, Alex S.L.

Abstract

In this paper we study a continuous-time, optimal stopping model of an asset sale with prospect theory preferences under pre-commitment. We show for a wide range of value and probability weighting functions, including those of Tversky and Kahneman (1992), that the optimal prospect takes the form of a stop-loss threshold and a distribution over gains. It is skewed with a long right tail. This is consistent with both the widespread use of stop-loss strategies in financial markets, and recent experimental evidence. Moreover, our model with probability weighting in tandem with the S-shaped value function makes predictions for the disposition effect which match in magnitude that calculated by Odean (1998).

Suggested Citation

  • Henderson, Vicky & Hobson, David & Tse, Alex S.L., 2018. "Probability weighting, stop-loss and the disposition effect," Journal of Economic Theory, Elsevier, vol. 178(C), pages 360-397.
  • Handle: RePEc:eee:jetheo:v:178:y:2018:i:c:p:360-397
    DOI: 10.1016/j.jet.2018.10.002
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    More about this item

    Keywords

    Prospect theory; Behavioral economics; Disposition effect; Investor trading behavior; Probability weighting;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G19 - Financial Economics - - General Financial Markets - - - Other
    • G39 - Financial Economics - - Corporate Finance and Governance - - - Other

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