The asymmetrical effect of price action on investor behavior is widely documented: When
stock prices decline, investors are less likely to sell. This disposition effect has more
recently been found to be nonlinear, with the absolute magnitude of price changes being
significant as well as the simple price change itself. The author investigates the asset
pricing implications of this effect. She presents a trading strategy to profit from the
effect, proposing price pressure from behaviorally motivated sellers as the source of the
The author builds on existing research in behavioral finance that shows that the
transaction rate for shareholders of a company increases when the price changes by larger
amounts. This effect is stronger for increases in price than for decreases, and in both
cases, the selling rate changes by more than the buying rate. She graphically represents
these facts as an asymmetrical V-shaped response to profit and loss. She shows the
predictability of stock returns based on the magnitude of unrealized gains and losses and
attributes this predictability to higher returns arising from a depressed stock price caused
by this V-shaped net selling pressure.
How Is This Research Useful to Practitioners?
Cross-sectional momentum in its simplest form has become a part of financial orthodoxy. The
author highlights that some nonlinearity exists in the response to price action that is not
fully consistent with this traditional view of momentum. This information can help shape
practitioners’ understanding of how momentum originates and thus whether they should
be looking at it in their process. It might also have implications in terms of the
definition of momentum that is appropriate to a given application.
Portfolio managers might be inspired to reflect on the timing of their continued investment
decision; a price action–agnostic process might result in more rational reevaluation
of investment theses. The disposition effect is a subtle but well-evidenced feature of
financial behavior that may be hard to identify in one’s own process.
How Did the Author Conduct This Research?
The author begins by using brokerage data to establish the relationship between buying and
selling and to establish a set of control variables, including the positive and negative
returns to stocks in the dataset. Her results are consistent with prior literature and
confirm the significance of the change in sales and purchases with respect to change in
price, the asymmetry of that response, and the greater impact on sales. These results
motivate her price impact hypothesis as well as the capital gains overhang and V-shaped net
selling propensity that are later used as control variables.
The author establishes the relationship between these control variables and the subsequent
stock performance by using double portfolio sorts and regression analysis. Both show that
stocks with larger gains and losses have higher returns. The capital gains overhang effect
is strongly seasonal (presumably because of year-end tax effects), and the effects are
stronger for subsets of the dataset that are more speculative in nature—that is,
smaller companies and those with lower institutional ownership. The author reports that the
key results are robust to changes in treatment of stock splits and dividends, in universe
selection, in frequency of analysis, and in control variable construction.
The author presents a thorough and detailed description of a simple and intuitive
phenomenon along with strong support from wider literature. Perhaps the most interesting
implication of this work is how it informs the assumed causes of the momentum effect in the
cross section of stock returns. Behaviorally motivated selling as identified in this work
contributes nonmonotonically, which leaves much to the momentum effect to be explained by
purchases by new shareholders or by causes not corresponding to transactional price
pressure. An understanding of the origins of equity factors is increasingly important as a
tool to filter the growing number of identified pricing anomalies.