The Disposition Effect and Under-Reaction to News
Year: 2005
Type: article
Abstract: This paper develops a test of under-reaction to news induced by the presence of investors who display the tendency to realize gains and ride losses, known as the disposition effect. The disposition effect, a widely documented fact in investor behavior, implies that stock prices underreact more to bad news when more current holders are facing a capital loss, and under-react more to good news when more current holders are facing a capital gain. I use a database of mutual funds holdings to construct a measure of reference prices for individual stocks. Using this novel measure of reference price, I show that post-event predictability is most severe when the disposition effect predicts the biggest under-reaction. I show that exposure to a disposition variable spreads the cross-sectional differences in post-event returns: post-event drift is bigger when the news and the capital gains overhang have the same sign and the magnitude of the post-event drift is directly related to the amount of unrealized capital gains (losses) experienced by the stock holders prior to the event date.
Author: Andrea Frazzini
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W3125925449