Can Prospect Theory Explain the Disposition Effect? A New Perspective on Reference Points
43 Pages Posted: 27 May 2011 Last revised: 5 Mar 2016
Date Written: February 2016
There is a recent debate on whether prospect theory can explain the disposition effect. Using both theory and simulation, this paper shows that prospect theory often predicts the disposition effect when lagged expected final wealth is the reference point, regardless of whether the reference point is updated or not. When initial wealth is the reference point, however, there is often no disposition effect. Reference point adjustment weakens the disposition effect, leads to more aggressive initial stock purchase strategies and predict history-dependence in stock holding. These findings also provide a explanation for why market experience reduces behavioral biases.
Keywords: disposition effect, prospect theory, loss aversion, reference point
JEL Classification: G02, D03
Suggested Citation: Suggested Citation