Probability Weighting, Stop-Loss and the Disposition Effect

Abstract

Prospect theory (PT) has long been linked with the disposition effect. Despite significant progress made in rigorously modeling the trading behavior of PT investors, the predicted disposition effect is typically too strong relative to empirical findings. The literature has been largely silent on the effect of probability weighting. We incorporate probability weighting into a dynamic PT model and find investors desire a long right-tailed distribution over gains together with a stop-loss threshold. Probability weighting enables a PT model to match the magnitude of the disposition effect in Odean (1998).