Disposition effect as a behavioral trading activity elicited by investors' different risk preferences

This paper draws on numerical simulations to discuss the mechanism driving the disposition effect. The computational model is constructed from the basic ideas of prospect theory. The objective (or crude) rewards, obtained from investment, are transformed into subjective rewards via the value function proposed by prospect theory, which characterizes risk-aversion in gains and risk-seeking in losses. The optimal action is then chosen by maximizing the expected value of future subjective rewards. The results of numerical simulations of a finite-period optimal investment problem show that the disposition effect is given as its optimal solution, where the risk-seeking in losses is considered to play a key role in driving the effect.