Prospect Theory, Liquidation and the Disposition Effect

34 Pages Posted: 17 Feb 2009 Last revised: 3 Oct 2011

Date Written: February 15, 2009

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

Suggested Citation

Henderson, Vicky, Prospect Theory, Liquidation and the Disposition Effect (February 15, 2009). EFA 2009 Bergen Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1343761 or http://dx.doi.org/10.2139/ssrn.1343761

Vicky Henderson (Contact Author)

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom
44 (0)2476 574811 (Phone)

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