Prospect Theory and Liquidation Decisions
30 Pages Posted: 19 May 2005
Date Written: February 8, 2005
We solve a liquidation problem for an agent with preferences consistent with the prospect theory of Kahneman and Tversky (1978). We find that the agent is willing to hold a risky project with a relatively inferior Sharpe ratio if the project is currently making losses, and intends to liquidate it when it breaks even. On the other hand, the agent may liquidate a project with a relatively superior Sharpe ratio if its current profits rise or drop to the break-even point. Our results capture the spirit of the disposition effect and the break-even effect documented in empirical and experimental studies.
Keywords: Loss aversion, disposition effect; break-even effect
JEL Classification: G39, G19, D81
Suggested Citation: Suggested Citation