Prospect Theory, Partial Liquidation And The Disposition Effect

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Executive Summary

The authors solve a liquidation problem for an agent with prospect theory preferences who seeks to sell a portfolio of (divisible) claims on an underlying asset. Their methodology enables them to consider different formulations of prospect preferences in the literature, and various asset price processes. They find that these differences in specification are important - for instance, with piecewise power functions (but not piecewise exponentials) the agent may voluntarily liquidate at a loss relative to break-even. Further, they find that the likelihood of liquidating at a (small) gain is much higher than liquidating at a (large) loss, consistent with the disposition effect documented in empirical and experimental studies.

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