Does Prospect Theory Explain the Disposition Effect?

38 Pages Posted: 13 Mar 2007

See all articles by Thorsten Hens

Thorsten Hens

University of Zurich - Department of Banking and Finance; Norwegian School of Economics and Business Administration (NHH); Swiss Finance Institute

Martin Vlcek

University of Zurich - Department of Economics

Date Written: December 22, 2005

Abstract

The disposition effect is the observation that investors hold winning stocks too long and sell losing stocks too early. A standard explanation of the disposition effect refers to prospect theory and in particular to the asymmetric risk aversion according to which investors are risk averse when faced with gains and risk-seeking when faced with losses. We show that for reasonable parameter values the disposition effect can however not be explained by prospect theory as proposed by Kahneman and Tversky. The reason is that those investors who sell winning stocks and hold loosing assets would in the first place not have invested in stocks. That is to say the standard prospect theory argument is sound ex-post, assuming that the investment has taken place, but not ex-ante, requiring that the investment is made in the first place.

Keywords: Disposition effect, prospect theory, portfolio choice

Suggested Citation

Hens, Thorsten and Vlcek, Martin, Does Prospect Theory Explain the Disposition Effect? (December 22, 2005). NHH Dept. of Finance & Management Science Discussion Paper No. 18/2005, Available at SSRN: https://ssrn.com/abstract=970450 or http://dx.doi.org/10.2139/ssrn.970450

Thorsten Hens (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 32
Zurich, 8032
Switzerland
+41-44 634 37 06 (Phone)

Norwegian School of Economics and Business Administration (NHH)

Helleveien 30
Bergen, 5045
Norway

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Martin Vlcek

University of Zurich - Department of Economics ( email )

Zuerich, 8006
Switzerland

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