The Disposition Effect and Underreaction to News
Read the paperopens doi.org in a new tab
What they found
Frazzini asked whether the disposition effect matters for prices, not just for the investors who exhibit it. Using mutual fund holdings to estimate the average purchase price of each stock's holders, he showed that stocks trading at a large paper gain to their holders underreact to good news (holders sell into it, capping the move) and stocks at a large paper loss underreact to bad news (holders refuse to sell). The post-earnings-announcement drift was much larger for stocks where the disposition effect predicted resistance, and a strategy exploiting this earned significant abnormal returns.
What you can use
- The disposition effect of other investors creates predictable price drift: good news on a stock full of sitting gains takes longer to be fully priced.
- Knowing where the average holder's cost basis sits is a real input, because it predicts who will sell into a move.
- Post-earnings drift is strongest where the crowd is anchored, which is a way to prioritize which earnings moves to follow.
Caveats
Cost basis is estimated from quarterly fund holdings, which is imprecise. The trading strategy is long-short and gross of costs. Sample 1980 to 2002.
Tags: behavioral, disposition-effect, underreaction, earnings-drift
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.