S/F/83. The disposition effect: critically discuss whether behavioural finance should replace traditional financial and investment theories if the assumption of rationality does not hold true

Many traditional financial and investment theories are based upon the assumption of shareholder rationality, for instance portfolio theory, market efficiency and capital asset pricing model. However there is evidence that such rationality may not hold, shown in the following quote: ‘corporate managers and shareholders are well aware of a tendency ‘to throw good money after bad” by continuing to operate losing ventures (or holding falling shares) in the hope that a recovery will somehow take place’ Shefrin, H and Statman, M. (1985),’The disposition to sell winners too early and ride losers too long: Theory and Evidence’, Journal of Finance, vol 40, number 3, page789. This paper briefly outlines disposition effect and critically discusses whether behavioural finance should replace traditional financial and investment theories if the assumption of rationality does not hold true.