Daniel Reck, London School of Economics

The Disposition Effect and The Character of Reference Dependence: Theory and Evidence


Abstract

A central tenet of behavioral finance is that investors are more reluctant to realize losses than gains -- the disposition effect. Using US population tax data on capital gains realizations, we find that the disposition effect is only exhibited by day traders. The disposition effect disappears for assets held for more than 30 days, and is virtually entirely driven by investors who primarily trade on very short horizons. This finding questions the previously held belief that the disposition effect is a wide-ranging phenomenon affecting most investors.
Empirically, the disposition effect results from a large discontinuity in the probability of realizing a gain or loss exactly a zero return. We show theoretically that this discontinuity implies a notch in traders' valuation of the prospect of realizing a gain or loss at zero -- conventional prospect theory predicts a kink, not a notch. We conclude that the disposition effect is  driven by a small minority of overactive traders, who are subject to a peculiar form of reference dependence.

Daniel Reck is Assistant Professor of Economics at the London School of Economics. His research interests are primarily in behavioral welfare economics and public economics. More broadly, he takes an interest in the combination of administrative datasets and theoretical reasoning to study a variety of topics in applied microeconomics. His recent research projects include the effect of recent enforcement efforts on tax evasion via offshore accounts in the US, the development and application of tools for recovering preferences from choice data when seemingly arbitrary factors like defaults affect choice, the optimal design of defaults, and the effects of minimum wage rules on youth employment.

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