Prospect Theory, Liquidation and the Disposition Effect

Abstract

There is a well known intuition linking prospect theory with the disposition effect, the tendency of investors to sell assets that have risen in value rather than fallen. Recently, several authors have studied rigorous models in an attempt to formalize the intuition. However, some have found it difficult to predict a disposition effect whilst others produce a more extreme prediction where investors never voluntarily sell at a loss. We solve a model of asset liquidation where investors realize utility over gains and losses, and utility is concave over gains, and convex over losses. Under the preferences of Tversky and Kahneman (1992) and lognormal asset prices, investors exhibit a disposition effect as gains are realized at a greater rate than losses. Nonetheless, in contrast to the extant literature, we find that the investor will ``give up'' and sell at a loss, when the asset has a sufficiently low Sharpe ratio.

Keywords: Prospect theory, behavioral finance, disposition effect, liquidation, optimal stopping

JEL Classification: D81, G19, G39