Does Prospect Theory Explain the Disposition Effect?

The disposition effect is the observation that investors tend to realize gains more than losses. This behavior is puzzling because it cannot be explained by traditional finance theories. 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 with losses. We show that for reasonable parameter values, the disposition effect cannot, however, be explained by prospect theory. The reason is that those investors who sell winning stocks and hold losing assets would not have invested in stocks in the first place. That is, the standard prospect theory argument is sound ex-post, assuming that the investment occurred, but not ex-ante, requiring also that the investment has to be made in the first place.