Prospect Theory and Liquidation Decisions

We solve a liquidation problem for an agent with preferences consistent with the prospect theory of Kahneman and Tversky [Econometrica 47 (1979) 263–291]. We find that the agent is willing to hold a risky project with a relatively inferior Sharpe ratio if the project is currently making losses, and intends to liquidate it when it breaks even. On the other hand, the agent may liquidate a project with a relatively superior Sharpe ratio if its current profits rise or drop to the break-even point. Our results capture the spirit of the disposition effect and the break-even effect documented in empirical and experimental studies.

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