Prospect Theory, the Disposition Effect, and Asset Prices

70 Pages Posted: 8 Mar 2011 Last revised: 26 Feb 2016

See all articles by Yan Li

Yan Li

Temple University - Fox School of Business and Management

Liyan Yang

University of Toronto - Rotman School of Management

Date Written: March 8, 2011

Abstract

We build a general equilibrium model to examine the implications of prospect theory for the disposition effect, asset prices, and trading volume. Diminishing sensitivity predicts a disposition effect, price momentum, a reduced return volatility, and a positive return-volume correlation. Loss aversion generally predicts the opposite. In calibrated economies, there is a nontrivial range of preference parameters for prospect theory to simultaneously explain the disposition effect, the momentum effect, and the equity premium puzzle. Our model is helpful for understanding a wide range of financial phenomena and it also suggests new testable predictions.

Keywords: Prospect theory, Disposition effect, Momentum, Reversal

JEL Classification: G11, G12

Suggested Citation

Li, Yan and Yang, Liyan, Prospect Theory, the Disposition Effect, and Asset Prices (March 8, 2011). Journal of Financial Economics, 2013, 107(3): 715-739. Available at SSRN: https://ssrn.com/abstract=1781382 or http://dx.doi.org/10.2139/ssrn.1781382

Yan Li

Temple University - Fox School of Business and Management ( email )

Philadelphia, PA 19122
United States

Liyan Yang (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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