Abstract

The behavior of investors is often at odds with the assumptions of traditional finance theory. Research conducted over the past half-century or so abounds with examples in which the central axioms of traditional theory are systematically violated. One of the most well-established behavioral patterns in this context is the disproportionate tendency of investors to sell stocks that have appreciated in value since purchase (‘winners’) rather than stocks that have declined in value (‘losers’); this phenomenon is known as the disposition effect and most commonly attributed to Kahneman and Tversky’s (1979) prospect theory. The overall aim of this doctoral thesis is to investigate the robustness of this phenomenon, its underlying mechanisms, and its potential implications for individual investors.

The four independent but related essays of this thesis were designed to answer the following research questions: (1) Does the disposition effect ‘survive’ bear markets, in which investors may not be able to realize gains even if they wish to do so? (2) Is there any supporting evidence for prospect theory-based explanation of the disposition effect in the form of other observed behavior consistent with the theory? (3) Is prospect theory the most feasible explanation for the disposition effect? (4) What are the implications of the disposition effect from the point of view of individual investors?

Using comprehensive data covering virtually all trades executed in the Finnish stock market during 1995–2003, this thesis demonstrates the following: (1) As robust as the disposition effect appears to be in light of previous studies, the phenomenon is only partially detected in bear markets. (2) The relationship between prospect theoretic preferences and investor behavior is not easily generalizable to other behavioral patterns besides the disposition effect. (3) In fact, even the relationship between prospect theory and the disposition effect is not as strong as is generally believed. Our results instead suggest an explanation based on escalation of commitment, according to which the disposition effect is caused above all by self-justificatory concerns. (4) Finally, although the disposition effect is generally inconsistent with economic rationality, it does not appear to be detrimental to investment performance.