Can Prospect Theory Explain the Disposition Effect? A New Perspective on Reference Points∗

There is a recent debate on whether prospect theory can explain the disposition effect. Using both theory and simulation, this paper shows that prospect theory often predicts the disposition effect when lagged expected final wealth is the reference point under the principle of preferred personal equilibrium, regardless of whether the reference point is updated or not. When initial wealth is the reference point, however, there is often no disposition effect. When reference point has no lag or is determined under the principle of disappointment aversion, such a model cannot explain why the investor bought the stock in the first place. Reference point adjustment weakens the disposition effect, leads to more aggressive initial stock purchase strategies and predict history-dependence in stock holding.