A Rational Explanation of Disposition Effect: Portfolio Rebalancing with Transaction Costs

Abstract

The disposition effect (i.e., the tendency of investors to sell winners while holding on to losers) has been widely documented, and behavioral explanations have dominated the extant literature. In this paper, we develop a portfolio rebalancing model with transaction costs to explain the disposition effect. We show that almost all of the disposition effect patterns found in the existing literature are consistent with the optimal trading strategies implied by our model, with or without capital gains tax. In addition, selling winners that tend to subsequently outperform held losers can be optimal.