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What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation

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  • Nicholas Barberis
  • Wei Xiong

Abstract

One of the most striking portfolio puzzles is the %u201Cdisposition effect%u201D: the tendency of individuals to sell stocks in their portfolios that have risen in value since purchase, rather than fallen in value. Perhaps the most prominent explanation for this puzzle is based on prospect theory. Despite its prominence, this explanation has received little formal scrutiny. We take up this task, and analyze the trading behavior of investors with prospect theory preferences. We find that, at least for the simplest implementation of prospect theory, the link between these preferences and the disposition effect is not as obvious as previously thought: in some cases, prospect theory does indeed predict a disposition effect, but in others, it predicts the opposite. We provide intuition for these results, and identify the conditions under which the disposition effect holds or fails. We also discuss the implications of our results for other disposition-type effects that have been documented in settings such as the housing market, futures trading, and executive stock options.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12397.

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Date of creation: Jul 2006
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Publication status: published as Nicholas Barberis & Wei Xiong, 2009. "What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation," Journal of Finance, American Finance Association, vol. 64(2), pages 751-784, 04.
Handle: RePEc:nbr:nberwo:12397
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Find related papers by JEL classification:
  • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
  • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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  1. Cox, John C. & Huang, Chi-fu, 1989. "Optimal consumption and portfolio policies when asset prices follow a diffusion process," Journal of Economic Theory, Elsevier, vol. 49(1), pages 33-83, October.
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  10. David Genesove & Christopher Mayer, 2001. "Loss Aversion and Seller Behavior: Evidence from the Housing Market," NBER Working Papers 8143, National Bureau of Economic Research, Inc.
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  12. Kyle, Albert S. & Ou-Yang, Hui & Xiong, Wei, 2006. "Prospect theory and liquidation decisions," Journal of Economic Theory, Elsevier, vol. 129(1), pages 273-288, July.
  13. 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.
  14. Nicholas Barberis & Ming Huang & Richard H. Thaler, 2006. "Individual Preferences, Monetary Gambles, and Stock Market Participation: A Case for Narrow Framing," American Economic Review, American Economic Association, vol. 96(4), pages 1069-1090, September.
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