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Prospect Theory and the Disposition Effect

Published online by Cambridge University Press:  28 April 2010

Markku Kaustia
Markku Kaustia*
Affiliation:
Aalto University, School of Economics, PO Box 21210, FI-00076 AALTO, Helsinki, Finland. [email protected]
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Abstract

This paper shows that prospect theory is unlikely to explain the disposition effect. Prospect theory predicts that the propensity to sell a stock declines as its price moves away from the purchase price in either direction. Trading data, on the other hand, show that the propensity to sell jumps at zero return, but it is approximately constant over a wide range of losses and increasing or constant over a wide range of gains. Further, the pattern of realized returns does not seem to stem from optimal after-tax portfolio rebalancing, a belief in mean-reverting returns, or investors acting on target prices.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 3 , June 2010 , pp. 791 - 812
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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