Blog - Investing Notes

August 1, 2005 – The Disposition Effect as a Driver of Momentum's Excess Returns

In the February 2005 update to his paper entitled "The Disposition Effect and Under-reaction to News", Andrea Frazzini tests whether the "disposition effect" (the tendency of investors to sell stocks that have gone up, not down, in value since purchase) causes stock prices to under-react to bad news when most current holders face a capital loss and under-react to good news when most current holders face a capital gain. Using a database of the holdings of a large class of investors (mutual funds) to estimate reference prices for individual stocks, he ranks stocks according to unrealized capital gains/losses and correlates this ranking with response to corporate news and subsequent return. Based on data spanning 1980-2002, he finds that:

• Like ordinary investors, mutual fund managers tend to sell a higher proportion of their winners than their losers.
• Predictability of returns after news reports is strongest when the disposition effect indicates the biggest under-reaction (when unrealized capital gains/losses are extreme).
• Post-event drift is larger when the news and the unrealized capital gains/losses have the same sign, and the magnitude of the drift is directly related to the magnitude of unrealized stockholder capital gains/losses prior to the event date.
• Stocks with large unrealized capital gains (losses) tend to have higher (lower) subsequent returns. Event-driven strategies based on this effect yield monthly excess returns of about 1% after transaction costs.
• These results suggest that the disposition effect may drive both price and earnings momentum, and that past returns may be a noisy measure of the unrealized capital gains of stock holders. Positive (negative) news travels slowly in stocks with large capital gains (losses) as disposition effect trading dampens transmission of information, thus feeding return continuation.

In summary, the disposition effect may serve as the bootstrap of momentum investing by retarding the impact of good (bad) news for stocks with large unrealized capital gains (losses).

For related research, see Blog Synthesis: Momentum Investing/Trading.