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Does Prospect Theory Explain the Disposition Effect?

Author

Listed:
  • Thorsten Hens
  • Martin Vlcek

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.

Suggested Citation

  • Thorsten Hens & Martin Vlcek, 2006. "Does Prospect Theory Explain the Disposition Effect?," IEW - Working Papers 262, Institute for Empirical Research in Economics - University of Zurich.
    • Handle: RePEc:zur:iewwpx:262
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    File URL: https://www.zora.uzh.ch/id/eprint/52219/1/iewwp262.pdf
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    References listed on IDEAS

    as
    1. Chip Heath & Steven Huddart & Mark Lang, 1999. "Psychological Factors and Stock Option Exercise," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 114(2), pages 601-627.
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    5. 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.
    6. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    7. 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, vol. 40(3), pages 777-790, July.
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    Cited by:

    1. Tõnn Talpsepp, 2010. "Does Gender and Age Affect Investor Performance and the Disposition Effect?," Research in Economics and Business: Central and Eastern Europe, Tallinn School of Economics and Business Administration, Tallinn University of Technology, vol. 2(1).
    2. 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, vol. 71(2), pages 318-329, August.
    3. Han Bleichrodt & Alessandra Cillo & Enrico Diecidue, 2010. "A Quantitative Measurement of Regret Theory," Management Science, INFORMS, vol. 56(1), pages 161-175, January.

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    More about this item

    Keywords

    Disposition effect; prospect theory; portfolio choice;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior

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