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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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    Cited by:

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    2. Kleinberg, Jon & Kleinberg, Robert & Oren, Sigal, 2022. "Optimal stopping with behaviorally biased agents: The role of loss aversion and changing reference points," Games and Economic Behavior, Elsevier, vol. 133(C), pages 282-299.
    3. Karolis Liaudinskas, 2019. "Human vs. Machine: Disposition Effect Among Algorithmic and Human Day-traders," Working Papers 1133, Barcelona School of Economics.
    4. Alex S. L. Tse & Harry Zheng, 2019. "Speculative Trading, Prospect Theory and Transaction Costs," Papers 1911.10106, arXiv.org, revised Oct 2022.
    5. Yu, Yinyun & Li, Congdong & Fu, Yelin & Yang, Weiming, 2023. "A group decision-making method to measure national energy architecture performance: A case study of the International energy Agency," Applied Energy, Elsevier, vol. 330(PA).
    6. Karolis Liaudinskas, 2022. "Human vs. Machine: Disposition Effect among Algorithmic and Human Day Traders," Working Paper 2022/6, Norges Bank.
    7. Ebert, Sebastian & Hilpert, Christian, 2019. "Skewness preference and the popularity of technical analysis," Journal of Banking & Finance, Elsevier, vol. 109(C).

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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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