The disposition effect is one of the most robust findings in empirical finance. Investors sell winners too quickly and cling to losers for too long (a recent blog discussed how this makes sense in an evolutionary context). But the behavior lines up neatly with the S-shaped value function of prospect theory, so tying the two together has become almost reflexive: loss aversion makes people risk-seeking in losses and risk-averse in gains, so they hold losers and sell winners. Case closed.

Except it isn’t.

In an underappreciated paper (or at least underappreciated by me because I only just read it, 15 years after it was published) , Markku Kaustia asks a simple question: if prospect theory really explains the disposition effect, does it get the shape of selling behavior right? His answer is no. Not even close.

Prospect theory makes a very specific prediction. If the purchase price is the reference point, then as the price moves away from that reference in either direction, the investor’s propensity to sell should decline. The intuition is straightforward. In the trade makes money, the investor becomes increasingly risk-averse and prefers to lock in gains, but only near the reference point. Far from it, the marginal utility change flattens. If the stock loses money, risk-seeking behavior should reduce the desire to sell even more as losses deepen. That is, selling should be most likely near breakeven and fall off on both sides.

That is not what the data show.

Using a dataset of all Finnish household investors over several years, Kaustia estimates the probability of selling a stock as a function of its unrealized gain or loss. The result is striking. The propensity to sell jumps sharply at exactly zero return. Investors are far more likely to sell a stock that is up 1% than one that is down 1%. But once you move away from zero, the curve behaves very differently from prospect theory’s predictions. Over a wide range of losses, the selling probability is essentially flat. Investors do not become meaningfully more inclined to sell as losses grow. Over gains, the propensity to sell is increasing or roughly constant, not declining.

This pattern holds across holding periods from days to years. It weakens with time, but it does not reverse. The defining feature is the discontinuity at breakeven, not the curvature away from it.

That single fact already breaks the standard prospect theory story. With realistic parameterizations of the value function, prospect theory does not predict selling across a broad range of gains. In fact, Kaustia shows that under canonical parameters, a prospect-theory investor should not voluntarily realize gains of 5%, 10%, or even 20% at all. To force the model to match the data, you have to push the parameters into ranges that contradict experimental estimates of loss aversion and risk preferences.

Kaustia then systematically walks through the usual fallback explanations. It isn’t taxes: optimal tax trading predicts realizing losses eagerly and deferring gains, the opposite of what we see. It isn’t mean reversion beliefs: if investors were selling because they expected reversals, they would sell losing stocks that recently outperformed and hold winning stocks that recently underperformed. The data show the opposite. It isn’t target prices either: if investors were waiting for subjective fair value, the purchase price should lose its psychological grip over time or after large price excursions. It doesn’t. Zero remains special.

What remains is not a clean utility function but something messier and more human. The sharp kink at breakeven is consistent with mental accounting and self-justification. Selling at a loss requires admitting a mistake. Selling at a gain allows the mental account to be closed cleanly. The behavior looks less like continuous optimization and more like threshold-based bookkeeping. It could also just be that active traders are making decisions around the entry point and passive investors just don’t look at the statements.

For investors, this matters because it is a warning about explanatory overreach. Prospect theory is a useful descriptive framework in many contexts but invoking it mechanically can blind you to what the data are actually saying. The disposition effect is real, but it is not simply “loss aversion in action.” It is a behavioral pattern with a very specific empirical fingerprint, and that fingerprint does not match the textbook story.

The broader lesson is methodological. If a theory is true, it should get the shape of behavior right, not just the sign. Matching averages is easy. Matching functional form is hard. And when you bother to look closely, many comfortable explanations quietly fall apart.

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