How Prospect Theory and the Disposition Effect Influence Prices

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█ Prospect theory, the disposition effect, and asset prices
In the research paper "Prospect Theory, the Disposition Effect, and Asset Prices," authors Yan Li and Liyan Yang delve into the implications of prospect theory on asset pricing and trading volume through the lens of the disposition effect.

The disposition effect, a tendency to sell assets that have increased in value while holding onto assets that have declined, is a well-documented behavioral bias among investors.

Results: The study finds that diminishing sensitivity predicts a disposition effect, price momentum, reduced return volatility, and a positive return-volume correlation. Conversely, loss aversion generally predicts opposite outcomes.

█ Background and Theory
⚪ Agency theory examines the relationship between principals (owners) and agents (managers), focusing on aligning their interests through contracts and incentives.




⚪ Prospect theory, introduced by Kahneman and Tversky (1979), is a behavioral model that describes how people make decisions involving risk and uncertainty. Unlike traditional utility theory, prospect theory suggests that people value gains and losses differently, leading to risk-averse behavior for gains and risk-seeking behavior for losses.

Explanation of Risk Aversion and Loss Aversion
Risk aversion is the tendency to prefer certainty over a gamble with a higher or equal expected value. In contrast, loss aversion implies that losses loom larger than gains, making individuals more sensitive to potential losses than to equivalent gains.

This phenomenon is captured by the S-shaped value function in prospect theory, which is concave for gains and convex for losses.




█ Methodology
The research uses a comprehensive model to understand how psychological factors like fear of losses and changing sensitivity to gains and losses affect trading and market behavior. This model looks at both diminishing sensitivity (caring less about bigger changes) and loss aversion (fear of losing money) together. The study's data comes from traders and managers at four big investment banks, including people with different levels of experience and jobs. This gives a broad view of how trading behavior works at these banks.

█ Findings
Disposition Effect

• What's Happening: Investors tend to sell stocks that have gone up in value and hold onto stocks that have gone down.
  
• Why: Because they are highly sensitive to gains but less sensitive to losses.
  
• Evidence: The study shows that people are about 15% more likely to sell stocks that have gone up than those that have gone down.
  

Price Momentum

• What's Happening: Because of the disposition effect, stock prices keep moving in the same direction for a while before correcting.
  
• Why: Investors sell winning stocks quickly and hold onto losing ones, so prices don’t adjust immediately to new information.
  
• Evidence: Stocks that performed well continue to do better than those that performed poorly, by about 1% per month over six months to a year.
  

Higher Equity Premium

• What's Happening: Investors demand higher returns for holding riskier stocks due to fear of losses.
  
• Why: Loss aversion makes them want more return to compensate for the risk.
  
• Evidence: Historically, stocks have returned about 6% more per year than risk-free assets, which is known as the equity premium puzzle.
  

█ Practical Implications for Retail Traders
Retail traders can derive several practical applications from these findings to improve their trading strategies:

• Risk Management: Understanding that loss aversion may lead to holding losing stocks longer, traders should implement strict stop-loss policies to mitigate this bias.
  
• Profit-Taking Strategies: Recognizing the reversed disposition effect, traders should establish clear profit-taking rules to avoid prematurely selling winning stocks.
  
• Market Volatility Awareness: Being aware that market volatility can exacerbate loss aversion effects, traders should seek higher returns to compensate for perceived risks.
  

█ Applying Knowledge from the Study
Retail traders can apply the knowledge from this study in several effective ways:

• Implementing Stop-Loss Orders: Setting automatic stop-loss orders helps circumvent the emotional impact of loss aversion, ensuring losses are capped at predetermined levels.
  
• Regular Review of Holdings: Periodic reassessment of stock holdings can help overcome the inertia caused by loss aversion, enabling more rational decision-making.
  
• Diversification: Diversifying the portfolio can mitigate the impact of loss aversion on individual stock performance, reducing overall portfolio risk.
  
• Education on Cognitive Biases: Educating themselves about cognitive biases like loss aversion and the disposition effect can help traders recognize and counteract these biases in their trading behavior.
  

█ Reference
Li, Y., & Yang, L. (2013). Prospect theory, the disposition effect, and asset prices. Journal of Financial Economics, 107(3), 715-739. doi:10.1016/j.jfineco.2012.11.002


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