What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation

48 Pages Posted: 3 Aug 2006  

Nicholas Barberis

Yale School of Management; National Bureau of Economic Research (NBER)

Wei Xiong

Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: July 2006

Abstract

One of the most striking portfolio puzzles is the %u201Cdisposition effect%u201D: the tendency of individuals to sell stocks in their portfolios that have risen in value since purchase, rather than fallen in value. Perhaps the most prominent explanation for this puzzle is based on prospect theory. Despite its prominence, this explanation has received little formal scrutiny. We take up this task, and analyze the trading behavior of investors with prospect theory preferences. We find that, at least for the simplest implementation of prospect theory, the link between these preferences and the disposition effect is not as obvious as previously thought: in some cases, prospect theory does indeed predict a disposition effect, but in others, it predicts the opposite. We provide intuition for these results, and identify the conditions under which the disposition effect holds or fails. We also discuss the implications of our results for other disposition-type effects that have been documented in settings such as the housing market, futures trading, and executive stock options.

Suggested Citation

Barberis, Nicholas and Xiong, Wei, What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation (July 2006). NBER Working Paper No. w12397. Available at SSRN: https://ssrn.com/abstract=921563

Nicholas Barberis (Contact Author)

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-436-0777 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Wei Xiong

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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