Disposition Effect and Diminishing Sensitivity: An Analysis Based on a Simulated Experimental Stock Market

We experimentally investigate the existence of the disposition effect and diminishing sensitivity as its potential cause. Our approach includes three key characteristics: (i) An environment closely resembling actual stock markets; (ii) Individual-specific reference prices; (iii) A direct test of diminishing sensitivity as a cause of the disposition effect. We find strong support for the existence of the disposition effect as an independent hypothesis. This is an improvement over previous studies, which tested this hypothesis only jointly with others. Our results also strongly point to diminishing sensitivity, of the type postulated by prospect theory, being a source of the disposition effect.