Prospect theory, the disposition effect, and asset prices

Yan Li and Liyan Yang

Journal of Financial Economics, 2013, vol. 107, issue 3, 715-739

Abstract: We build a general equilibrium model to examine the implications of prospect theory for the disposition effect, asset prices, and trading volume. Diminishing sensitivity predicts a disposition effect, price momentum, a reduced return volatility, and a positive return-volume correlation. Loss aversion generally predicts the opposite. In calibrated economies, there is a nontrivial range of preference parameters for prospect theory to simultaneously explain the disposition effect, the momentum effect, and the equity premium puzzle. Our model is helpful for understanding a wide range of financial phenomena and it also suggests new testable predictions.

Keywords: Prospect theory; Disposition effect; Momentum; Reversal; Turnover (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (54)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:107:y:2013:i:3:p:715-739

DOI: 10.1016/j.jfineco.2012.11.002

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