Winning Probability Dynamics and the Disposition Effect

Abstract

This paper studies the unique statistical features of multi-period returns vs. single-period returns and examines their implications on I derive a closed form representation of the dynamic relation between winning probability and holding time, and then apply the theoretical results to studying the disposition effect, which refers to the tendency of investors to be reluctant to realize losses. The winning probability refers to the probability that investors can make positive profits on their positions. The winning probability of multi-period investments evolves with the length of the holding period; the longer the holding periods, the larger or smaller the winning probability becomes, depending on the statistic properties of the stock price process. Such evolution of winning probability can lead to the observed disposition effects. Simulations with CRSP daily stock data show that the disposition effects can be replicated even when investors have no selling preference. Therefore the well-documented disposition effects may not be due to behavioral bias of investors, but rather probably due to statistical features of the financial market data. The puzzle of disposition effects can be solved within the economic framework in which market participants are rational agents.

Keywords: Disposition Effect, Rational Agent Assumption, Behavioral Finance, Dynamic model

JEL Classification: G14, G10