Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2005/18: Does Prospect Theory Explain the Disposition Effect?

Thorsten Hens () and Martin Vlcek ()
Additional contact information
Thorsten Hens: Institute for Empirical Research in Economics, University of Zurich, Postal: University of Zurich, Institute for Empirical Research in Economics, Blümlisalpstrasse 10, 8006 Zürich, Switzerland
Martin Vlcek: Institute for Empirical Research in Economics, University of Zurich, Postal: University of Zurich, Institute for Empirical Research in Economics, Blümlisalpstrasse 10, 8006 Zürich, Switzerland

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

JEL-codes: G11

37 pages, December 22, 2005

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