A heterogeneous model of disposition effect

Abstract

A portfolio choice model is provided to illustrate the disposition effect under irrational belief in mean reversion assumption. Higher cognitive reference, stronger irrational belief in mean reversion magnitude and less risk aversion all strengthen the disposition effect in the model. The equilibrium market interest rate is priced after the market clearing condition is employed. The grater disposition effect reduces the capital mobility from the stock market to the bond market and thus mitigates the dropping of the market interest rate.

Notes

¹ Barberis and Thaler (2002) surveyed the irrational belief in mean reversion theory.

² Wang (1996) and Detemple and Murthy (1997) also provide heterogeneous agents and portfolio constraint models. Campbell (2000) surveys the heterogeneity in asset pricing at the millennium. Affuso (2002) and Holman and Graves (2002) empirically report the significant importance of heterogeneity by UK and US data respectively.

³ Arak and Taylor (1996) have developed and tested the mean-reverting model setup between foreign stocks and closed-end country funds.

⁴ Grinblatt and Keloharju (2001) have the similar empirical disposition effect results by using Finland data. They find that past returns have important influence in determining disposition behaviour and the seasonality plays another interesting issue as well.

⁵ Shapira and Venezia (2001) report some similar disposition results by using Israeli data. They show that not only the individual investors have the disposition effect but also do the institutional investors.

⁶ Dyl (1977), Constantinides (1984), Lakonishok and Smidt (1986), and Badrinath and Lewellen (1991) all provide evidence of disposition effect.

⁷ Locke and Mann (1999) provide the professional futures traders have tendency to hold losing trades with longer periods and larger positions than to hold winning trades.

⁸ The proof is available upon request.

⁹ It is the same to clear the stock market: sα₁ + (1 − s)α₂ = 1 .