Prospect Theory, Mental Accounting, and Momentum

38 Pages Posted: 9 Nov 2001  

Bing Han

University of Toronto, Rotman School of Management

Mark Grinblatt

University of California, Los Angeles (UCLA) - Finance Area; Yale University - International Center for Finance; National Bureau of Economic Research (NBER)

Date Written: August 2004

Abstract

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.

Keywords: prospect theory, mental accounting, disposition effect, momentum

JEL Classification: G12, G14

Suggested Citation

Han, Bing and Grinblatt, Mark, Prospect Theory, Mental Accounting, and Momentum (August 2004). Yale ICF Working Paper No. 00-71; UCLA Anderson School Finance Working Paper No. 01-18; AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=288466 or http://dx.doi.org/10.2139/ssrn.288466

Bing Han (Contact Author)

University of Toronto, Rotman School of Management ( email )

Toronto, Ontario M5S 3E6
Canada
4169460732 (Phone)

Mark Grinblatt

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1098 (Phone)
310-206-5455 (Fax)

Yale University - International Center for Finance

Box 208200
New Haven, CT 06520-8200
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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