What Drives the Disposition Effect? An Analysis of a Long‐Standing Preference‐Based Explanation

TLDR

The study examines whether prospect theory preferences predict the disposition effect. The authors compare two prospect‑theory models—one based on annual gains/losses and one on realized gains/losses—to assess their predictive power. Surprisingly, the annual gain/loss model often fails to predict a disposition effect, whereas the realized gain/loss model predicts it more reliably, suggesting that utility from realized gains and losses may be a useful framework for certain investor trading behaviors.

Abstract

ABSTRACT We investigate whether prospect theory preferences can predict a disposition effect. We consider two implementations of prospect theory: in one case, preferences are defined over annual gains and losses; in the other, they are defined over realized gains and losses. Surprisingly, the annual gain/loss model often fails to predict a disposition effect. The realized gain/loss model, however, predicts a disposition effect more reliably. Utility from realized gains and losses may therefore be a useful way of thinking about certain aspects of individual investor trading.