Rational Disposition Effects: Theory and Evidence

The disposition effect is a longstanding puzzle in financial economics. This paper demonstrates that it is not intrinsically at odds with rational behavior. In a rational expectations model with asymmetrically informed investors, trading strategies as predicted by the disposition effect can arise as an optimal response to dynamic changes in the information structure. The model generates several novel predictions: the disposition behavior of unsophisticated investors should weaken after events that reduce information asymmetries and should be concentrated in stocks with weak price momentum. The data, trading records of 30,000 clients at a German discount brokerage firm from 1995 to 2000, are consistent with these predictions.