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Probability weighting, stop-loss and the disposition effect

Vicky Henderson, David Hobson and Alex S.L. Tse

Journal of Economic Theory, 2018, vol. 178, issue C, 360-397

Abstract: In this paper we study a continuous-time, optimal stopping model of an asset sale with prospect theory preferences under pre-commitment. We show for a wide range of value and probability weighting functions, including those of Tversky and Kahneman (1992), that the optimal prospect takes the form of a stop-loss threshold and a distribution over gains. It is skewed with a long right tail. This is consistent with both the widespread use of stop-loss strategies in financial markets, and recent experimental evidence. Moreover, our model with probability weighting in tandem with the S-shaped value function makes predictions for the disposition effect which match in magnitude that calculated by Odean (1998).

Keywords: Prospect theory; Behavioral economics; Disposition effect; Investor trading behavior; Probability weighting (search for similar items in EconPapers)
JEL-codes: D81 G19 G39 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:jetheo:v:178:y:2018:i:c:p:360-397