Does Prospect Theory Explain the Disposition Effect?

Thorsten Hens and Martin Vlcek

No 262, IEW - Working Papers from Institute for Empirical Research in Economics - University of Zurich

Abstract: The disposition e ect 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 rst 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 (search for similar items in EconPapers)
JEL-codes: C91 (search for similar items in EconPapers)
Date: 2006-01
New Economics Papers: this item is included in nep-fmk and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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