Disposition and Prospect Theory: Evidence from Insider Trading

Abstract

While most researchers agree on the existence of disposition, there still remains question regarding its cause. In this study, I investigate whether prospect theory is a potential cause by observing levels of disposition among insiders relative to information and risk. I find that while disposition increases for more volatile stocks, the increase is due strictly to an increase in the proportion of gains realized, and not in the decrease of the proportion of losses realized as well. This finding is inconsistent with the disjoint utility curve described by prospect theory, which implies risk seeking preferences for losses. Furthermore, I find that disposition doesn't decrease with superior information, a finding also inconsistent with prospect theory. Lastly, I find that disposition does decrease with financial sophistication, and that the belief in mean reversion does appear to contribute to the disposition effect, but not fully explain it.