The Disposition Effect and Expectations as Reference Points

Abstract

There is a recent debate on whether prospect theory can explain the disposition effect. Using both theory and simulation, this paper shows that prospect theory often predicts the disposition effect when lagged expected final wealth is the reference point, regardless of whether the reference point is updated or not. When initial wealth is the reference point, however, there is often no disposition effect. Reference point adjustment weakens the disposition effect, leads to more aggressive initial stock purchase strategies and predict history-dependence in stock holding. These findings also provide a explanation for why market experience reduces behavioral biases.