Probability Weighting, Stop-Loss and the Disposition Effect
58 Pages Posted: 16 Aug 2016 Last revised: 6 Mar 2017
Date Written: March 1, 2017
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: Suggested Citation