Does ambiguity drive the disposition effect?

Abstract

The disposition effect is a financial puzzle that is often reported in empirical studies. Although several theoretical explanations have been proposed, a unified view has yet to be reached to solve the puzzle. We explain the effect by extending the model of Barberis and Xiong (2009), which is the first to formally link prospect theory and disposition effects using a binomial model of stock prices by incorporating ambiguous attitudes under the Expected Utility with Uncertain Probabilities (EUUP) advocated by Izhakian (2017). In the behavioral setting constructed by Barberis and Xiong (2009), our model demonstrates significant progress in highlighting the importance of the realized annual terminal wealth and its impact on the disposition effect. We analytically show the threshold values of the perceived probability that the disposition effects appear. Our research finds that the disposition effect is observed when investors derive utility from the difference between the realized annual terminal wealth and the initial reference wealth point. We confirm this through a rigorous process of numerical examples.