Does Ambiguity Drive the Disposition Effect?

Abstract

The disposition effect is a frequently observed puzzle in financial markets. Although several theoretical explanations have been proposed, the disposition effect remains unresolved. We attempt to explain the effect by extending the model of Barberis and Xiong (2009), which is the first to formally link prospect theory and disposition effects using a binomial model of stock prices by incorporating ambiguous attitudes under the Expected Utility with Uncertain Probabilities (EUUP) advocated by Izhakian (2017). Using numerical examples, we confirm that the disposition effect is observed when investors derive utility from the difference between the realized annual terminal wealth and the initial reference wealth point.

Keywords: Disposition Effect, Prospect Theory, Ambiguity, Expected Utility with Uncertain Probabilities (EUUP)