A Dynamic Model of Investor Decision-Making: How Adaptation to Losses affects Future Selling Decisions

According to disposition effect theory, people hold losing investments too long. However, many investors eventually sell at a loss, and little is known about which psychological factors contribute to these capitulation decisions. This study integrates prospect theory, utility maximization theory, and theory on reference point adaptation to argue that the combination of a negative expectation about an investment’s future performance and a low level of adaptation to previous losses leads to a greater capitulation probability. The test of this hypothesis in a dynamic experimental setting reveals that a larger total loss and longer time spent in a losing position lead to downward adaptations of the reference point. Negative expectations about future investment performance lead to a greater capitulation probability. Consistent with the theoretical framework, empirical evidence supports the relevance of the interaction between adaptation and expectation as a determinant of capitulation decisions.