Prospect Theory Research Paper

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.

Empirical studies convincingly display that investors are generally reluctant to realize their losses, this is due to the disposition

One cannot rule out investor psychology in causing this effect. This paper attempts to assess the relative importance of prospect theory and other explanations for the disposition effect. When one takes the purchase price as the reference price in the value function, then the implication of prospect theory is that the tendency to sell a stock should decline as the stock price moves away from the purchase price irrespective of the direction. The regressions are run for different holding periods, and they include a host of control variables, such as past returns. In contrast to the mean-reversion hypothesis, outperformance actually decreases selling for loss-making positions. Third, it does not appear that holding on to losing shares is due to investors acting on target prices, based on their subjective assessment of the stock’s fair value. If investors’ trade based on target prices, then one would not expect the purchase price to be a target price, but rather

First, the empirical propensity to sell a stock is increasing or approximately constant as the gain increases, whereas a reasonable parameterization of a prospect theory value function predicts that the propensity to sell will decline as the gain increases. Second, the empirical propensity to sell is approximately constant in the domain of losses, while prospect theory again predicts it will decline as the loss increases. Prospect theory combined with exogenous liquidity shocks does predict that more gains are realized than losses. But even in that case, prospect theory predicts that the propensity to sell declines as the stock price moves away from the purchase price in either direction, a prediction that is clearly rejected by the data. Alternative rational explanations of the disposition effect do not fare well either. The empirical realization pattern is very different from that predicted for an investor considering taxes and portfolio rebalancing. Holding on to losing shares is not motivated by a belief in mean-reverting returns; the marginal tendency to realize a loss is actually smaller if a stock has recently outperformed the market. Finally, it does not appear that holding on to losing shares is due to investors acting on target prices, based on their subjective assessment of the stock’s fair value. Given the evidence discussed above, the question