The Disposition Effect under the Reference Dependent Smooth Model of Ambiguity

Abstract The disposition effect is a commonly observed puzzle in financial markets. Several theoretical explanations for the disposition effect have been provided; however, it remains unresolved. We attempt to explain the effect by incorporating ambiguity attitudes that vary depending on the reference point. We extend the smooth model of ambiguity by Klibanoff, P., M. Marinacci, and S. Mukerji. 2005. “A Smooth Model of Decision Making under Ambiguity.” Econometrica 73: 1849–92 to depend on the reference point. Numerical examples show that the disposition effect is more pronounced under our reference-dependent smooth model of ambiguity if the investor gets her/his utility from the realized gains and losses.