Prospect Theory, the Disposition Effect, and Asset Prices
70 Pages Posted: 8 Mar 2011 Last revised: 26 Feb 2016
Date Written: March 8, 2011
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: Suggested Citation