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Does Prospect Theory Explain the Disposition Effect?


Hens, Thorsten; Vlcek, Martin (2006). Does Prospect Theory Explain the Disposition Effect? Working paper series / Institute for Empirical Research in Economics No. 262, University of Zurich.

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 withnlosses. 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 notnhave invested in stocks. That is to say the standard prospect theory argument is sound ex-post, assuming that the investment has takennplace, but not ex-ante, requiring that the investment is made in the first place.

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 withnlosses. 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 notnhave invested in stocks. That is to say the standard prospect theory argument is sound ex-post, assuming that the investment has takennplace, but not ex-ante, requiring that the investment is made in the first place.

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Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Economics
Working Paper Series > Institute for Empirical Research in Economics (former)
Dewey Decimal Classification:330 Economics
Language:English
Date:January 2006
Deposited On:29 Nov 2011 22:47
Last Modified:07 Dec 2017 10:12
Series Name:Working paper series / Institute for Empirical Research in Economics
ISSN:1424-0459
Official URL:http://www.econ.uzh.ch/wp.html

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