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Economic and Statistical Significance of Disposition Effect and Momentum in the US Stock Market

Disposition effect is the tendency of investors to ride losses and lock in gains. Capital gains overhang is a quantity used in prior literature to construct hypothesis tests for the existence of the disposition effect using publicly available stock market data. This quantity estimates the difference between the current price of a stock and the average price at which the currently held shares of the stock have been purchased by their current owners. Momentum effect is the tendency of the recent price trends to persist. We construct a number of trading strategies based on the capital gains overhang and momentum. We use the US stock market data to show that these strategies were consistently profitable during 1980-2013, and negatively correlated with the market. These conclusions hold even after eliminating small-cap and small-price stocks that may be difficult to trade, and after introducing a realistic trading cost for every transaction. We find a high empirical correlation between the strategies based on momentum and on the capital gains overhang, and argue that the former may be preferable for practitioners because of better performance and simpler implementation. These results also suggest that, rather than measuring the disposition effect, the capital gains overhang may simply be a proxy for momentum. Our findings would be of interest to portfolio managers, quantitative traders, researchers who analyze financial signals, as well as ordinary investors seeking to avoid common investor biases.