The Disposition Effect and Momentum

Mark Grinblatt, Bing Han

NBER Working Paper No. 8734
Issued in January 2002
NBER Program(s):   AP

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.

download in pdf format
   (540 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w8734

Users who downloaded this paper also downloaded these:
Barberis and Xiong w12397 What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation
Goetzmann and Massa w9499 Disposition Matters: Volume, Volatility and Price Impact of a Behavioral Bias
Ang, Chen, and Xing w8643 Downside Risk and the Momentum Effect
Genesove and Mayer w8143 Loss Aversion and Seller Behavior: Evidence from the Housing Market
Jegadeesh and Titman w7159 Profitability of Momentum Strategies: An Evaluation of Alternative Explanations
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us