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The Disposition Effect and Momentum

45 Pages Posted: 24 Jan 2002  

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: January 2002

Abstract

Prior experimental and empirical research documents that many investors have a lower propensity to sell those stocks on which they have a capital loss. This behavioral phenomenon, known as 'the disposition effect,' has implications for equilibrium prices. We investigate the temporal pattern of stock prices in an equilibrium that aggregates the demand functions of both rational and disposition investors. The disposition effect creates a spread between a stock's fundamental value -- the stock price that would exist in the absence of a disposition effect -- and its market price. Even when a stock's fundamental value follows a random walk, and thus is unpredictable, its equilibrium price will tend to underreact to information. Spread convergence, arising from the random evolution of fundamental values, generates predictable equilibrium prices. This convergence implies that stocks with large past price runups and stocks on which most investors experienced capital gains have higher expected returns that those that have experienced large declines and capital losses. The profitability of a momentum strategy, which makes use of this spread, depends on the path of past stock prices. Crosssectional empirical tests of the model find that stocks with large aggregate unrealized capital gains tend to have higher expected returns than stocks with large aggregate unrealized capital losses and that this capital gains 'overhang' appears to be the key variable that generates the profitability of a momentum strategy. When this capital gains variable is used as a regressor along with past returns and volume to predict future returns, the momentum effect disappears.

Suggested Citation

Han, Bing and Grinblatt, Mark, The Disposition Effect and Momentum (January 2002). NBER Working Paper No. w8734. Available at SSRN: https://ssrn.com/abstract=298258

Bing Han

University of Toronto, Rotman School of Management ( email )

Toronto, Ontario M5S 3E6
Canada
4169460732 (Phone)

Mark Grinblatt (Contact Author)

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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