Examples Of Prospect Theory

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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. Empirical studies convincingly display that investors are generally reluctant to realize their losses, this is due to the disposition…show more content…
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 of what causes the disposition effect remains. According to it, investors essentially hold on to losing stocks to avoid confronting the fact that the investment decision was wrong. This is an application of self-justification theory. However, although the results are consistent with the psychological story, the present paper has not 26 subjected it to a test by which it can be refuted. Therefore, while rational explanations face challenges in accounting for the evidence, pronouncing them dead

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