Prospect Theory, Mental Accounting, and Momentum
University of Toronto, Rotman School of Management
University of California, Los Angeles (UCLA) - Finance Area; Yale University - International Center for Finance; National Bureau of Economic Research (NBER)
Yale ICF Working Paper No. 00-71; UCLA Anderson School Finance Working Paper No. 01-18; AFA 2003 Washington, DC Meetings
The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and updating of reference prices, generates predictable equilibrium prices that will be interpreted as possessing momentum. Cross-sectional empirical tests are consistent with the model. A variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Past returns have no predictability for the cross-section of returns once this variable is controlled for.
Number of Pages in PDF File: 38
Keywords: prospect theory, mental accounting, disposition effect, momentum
JEL Classification: G12, G14
Date posted: November 9, 2001
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