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Probability weighting, stop-loss and the disposition effect
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Henderson, Vicky, Hobson, David G. and Tse, Alex S. L. (2018) Probability weighting, stop-loss and the disposition effect. Journal of Economic Theory, 178 . pp. 360-397. doi:10.1016/j.jet.2018.10.002
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Official URL: https://doi.org/10.1016/j.jet.2018.10.002
Abstract
In this paper we study a continuous-time, optimal stopping model of an asset sale with prospect theory preferences under pre-commitment. We show for a wide range of value and probability weighting functions, including those of Tversky and Kahneman (1992), that the optimal prospect takes the form of a stop-loss threshold and a distribution over gains. It is skewed with a long right tail. This is consistent with both the widespread use of stop-loss strategies in financial markets, and recent experimental evidence. Moreover, our model with probability weighting in tandem with the S-shaped value function makes predictions for the disposition effect which match in magnitude that calculated by Odean (1998).
| Item Type: | Journal Article | ||||||||
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| Subjects: | H Social Sciences > HG Finance Q Science > QA Mathematics |
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| Divisions: | Faculty of Science > Statistics | ||||||||
| Library of Congress Subject Headings (LCSH): | Finance -- Mathematical models, Economics -- Psychological aspects -- Mathematical models | ||||||||
| Journal or Publication Title: | Journal of Economic Theory | ||||||||
| Publisher: | Elsevier | ||||||||
| ISSN: | 0022-0531 | ||||||||
| Official Date: | November 2018 | ||||||||
| Dates: |
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| Volume: | 178 | ||||||||
| Page Range: | pp. 360-397 | ||||||||
| DOI: | 10.1016/j.jet.2018.10.002 | ||||||||
| Status: | Peer Reviewed | ||||||||
| Publication Status: | Published | ||||||||
| Access rights to Published version: | Restricted or Subscription Access | ||||||||
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