What drives the disposition effect?

Heiko Zuchel

No 01-39, Papers from Sonderforschungsbreich 504

Abstract: Why do some investors tend to ''sell winners too early and ride losers too long''? Such behavior, labeled the disposition effect, has been attributed to biases in return expectations, time-varying risk-aversion based on the value function of prospect theory, and regret theory. I review these explanations and argue that none of them is satisfactory because they either fail to capture the disposition effect or because they are not supported by emprical evidence. I point out that there is a large psychological literature on entrapment, escalating commitment, and sunk cost that studies phenomena that are very similar to the disposition effect. This literature suggests an explanation of the disposition effect based on cognitive dissonance theory.

Date: 2001
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