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What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation




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    • Barberis is at the Yale School of Management. Xiong is at the Department of Economics, Princeton University. We are grateful to Campbell Harvey, an associate editor, two anonymous referees, John Campbell, Francisco Gomes, Mark Grinblatt, Bing Han, Xuedong He, Daniel Kahneman, George Loewenstein, Cade Massey, Mark Salmon, Jeremy Stein, Richard Thaler, Mark Westerfield, and seminar participants at Carnegie-Mellon University, Duke University, Imperial College, Northwestern University, Princeton University, Rutgers University, the Stockholm Institute for Financial Research, the University of California at Berkeley, the University of North Carolina, the University of Texas, the University of Warwick, the University of Wisconsin, Yale University, the Utah Winter Finance Conference, the Western Finance Association, and the NBER for helpful feedback.


We investigate whether prospect theory preferences can predict a disposition effect. We consider two implementations of prospect theory: in one case, preferences are defined over annual gains and losses; in the other, they are defined over realized gains and losses. Surprisingly, the annual gain/loss model often fails to predict a disposition effect. The realized gain/loss model, however, predicts a disposition effect more reliably. Utility from realized gains and losses may therefore be a useful way of thinking about certain aspects of individual investor trading.