Does Disposition Drive Momentum?

Momentum in stock prices was documented by Jegadeesh and Titman (1993) and a number of subsequent authors. Grinblatt and Han (2005) present a relatively simple theory in which momentum is driven by the disposition effect. Intuitively, if disposition-prone investors are holding a stock for which good news is revealed, they will sell their shares as prices rise (as the disposition effect predicts), decreasing any upward pressure on the stock price. Similarly, if disposition-prone investors are holding a stock for which bad news is revealed, they will hold their shares rather than sell on the news, again decreasing any downward pressure on the stock price. If any rational investors trading against the disposition-prone investors do not fully adjust their demands for stocks to account for the disposition bias, prices will take a relatively long time to converge to equilibrium levels following large shocks. One implication of this theory is that the level of unrealized gains or losses among disposition-prone investors is a sufficient statistic for future returns. Past returns might predict future returns because they are a noisy proxy for unrealized gains or losses. In this project, we will test the hypothesis that the dispositon effect is a behavioral bias that drives stock price momentum. In our preliminary analysis using data from a large brokerage firm, we estimate the magnitude of the disposition effect for a sample of investors and firms. We find that a large majority of investors exhibit the disposition effect. An investor's disposition coefficient estimated with one year of data forecasts that investor's disposition effect and investment performance in subsequent years. More disposition-prone investors tend to trade less frequently and in smaller sizes than other investors. Sorting stocks by the net unrealized gains or losses of disposition-prone investors generates a statistically significant winner/loser spread of several percent per year. Our preliminary results suggest that disposition does indeed drive momentum. In our formal analysis, we would like to use brokerage databases from several countries to test the hypotheses. At the moment we have already acquired brokerage datasets from the U.S., Finland, Japan and China. We believe this project is going to be a comprehensive study on the determinants of momentum in stock returns.