Prospect Theory, Mental Accounting, and Momentum

Mark Grinblatt and Bing Han

Yale School of Management Working Papers from Yale School of Management

Abstract: The tendency of some investors to hold on to their losing stocks, driven by prospect theory and mental accounting, creates a spread between a stock's fundamental value and its equilibrium price, as well as price underreaction to information. Spread convergence, arising from the random evolution of fundamental values and updating of reference prices, generates predictable equilibrium prices that will be interpreted as possessing momentum. Cross-sectional empirical tests are consistent with the model. A variable proxying for aggregate unrealized capital gains appears to be the key variable that generates the profitability of a momentum strategy. Past returns have no predictability for the cross-section of returns once this variable is controlled for.

Keywords: prospect theory; mental accounting; disposition effect; momentum (search for similar items in EconPapers)
Date: 2001-11-01, Revised 2007-05-01
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Journal Article: Prospect theory, mental accounting, and momentum (2005)
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