Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)
Does Prospect Theory Explain the Disposition Effect?
() and Martin Vlcek
Abstract: The disposition effect 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 first 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.
Keywords: Disposition effect; prospect theory; portfolio choice; (follow links to similar papers)
JEL-Codes: G11; (follow links to similar papers)
37 pages, December 22, 2005
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