Probability Weighting, Stop-Loss and the Disposition Effect

58 Pages Posted: 16 Aug 2016 Last revised: 6 Mar 2017

Vicky Henderson

University of Warwick

David Hobson

University of Warwick

Alex S. L. Tse

University of Cambridge - Judge Business School

Date Written: March 1, 2017

Abstract

Prospect theory (PT) has long been linked with the disposition effect. Despite significant progress towards rigorously modeling the trading behavior of PT investors, the literature has been largely silent on the effect of probability weighting. In this paper we incorporate probability weighting into a continuous-time model of an asset sale and find that investors follow strategies which are stop-loss, but not of threshold form on gains. The optimal prospect is skewed with a long right-tail. Moreover, probability weighting enables our PT model to match the magnitude of the disposition effect in Odean (1998).

Keywords: Prospect theory, behavioral finance, disposition effect, investor trading behavior, probability weighting.

JEL Classification: D81, G19, G39

Suggested Citation

Henderson, Vicky and Hobson, David and Tse, Alex S. L., Probability Weighting, Stop-Loss and the Disposition Effect (March 1, 2017). Available at SSRN: https://ssrn.com/abstract=2823449 or http://dx.doi.org/10.2139/ssrn.2823449

Vicky Henderson (Contact Author)

University of Warwick ( email )

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

David Hobson

University of Warwick ( email )

CV4 7AL
United Kingdom

Alex S. L. Tse

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

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