Mirjam Lehenkari and Jukka Perttunen It is widely acknowledged that investor behavior is often at odds with traditional finance theory. More importantly, the recent literature abounds with examples in which investors systematically deviate from the tenets of such theories as rationality. One of the currently debated behavioral patterns arising from this line of research is the tendency of investors to hold losing investments too long and sell winning investments too soon. Shefrin and Statman (1985) have dubbed this phenomenon the ‘disposition effect.’1 The disposition effect is commonly interpreted as a consequence of human behavioral theories, most notably prospect theory. Kahneman and Tversky (1979) developed this descriptive theory of decision under risk as an alternative to expected utility theory.2 They formalized an S-shaped value function with three essential properties. First, instead of being defined over levels of wealth, the value function is defined in terms of gains and losses relative to a reference point. Second, the value function is concave above the reference point and convex below it, that is, the marginal value of both gains and losses diminishes with their magnitude. Third, the slope of the value function is steeper for losses than for gains, which implies greater detriment from a loss than utility from an equal gain. Jointly, these three properties cause risk aversion in the domain of gains and riskseeking in the domain of losses. Consequently, an investor with preferences described by the prospect theory value function is inclined to sell an asset that has gained value and...
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