The V-shaped Disposition Effect

This study investigates the asset pricing implications of the V-shaped disposition effect, a newly-documented behavior pattern characterized by investors being more likely to sell a security when the magnitude of their gains or losses on it increases. I find that, on an aggregate level, stocks with both large unrealized gains and large unrealized losses outperform others in the following month. This supports the conjecture that these stocks experience higher selling pressure, leading to lower current prices and higher future returns. This effect cannot be explained by momentum, reversal, or other known factors that affect future returns. A trading strategy based on this effect generates a monthly alpha of approximately 0.5%-1%, with a Sharpe ratio of 1.6. My findings also dispute the view that the disposition effect drives momentum; by isolating the disposition effect from gains versus that from losses, I find the loss side has a return prediction opposite to momentum. Overall, this study provides new evidence that investor tendencies can aggregate to affect price dynamics; it also challenges the current understanding of the disposition effect and sheds light on the pattern, source, and pricing implications of this behavior. ∗Department of Economics, Columbia University. E-mail: [email protected]. †I am deeply indebted to the members of my committee Patrick Bolton, Kent Daniel, and Paul Tetlock for many helpful discussions, guidance, and encouragement. I am also grateful for Bob Hodrick, Gur Huberman, Bernard Salanie, and Joseph Stiglitz for helpful comments and suggestions. All remaining errors are my own.