Disposition effect on stock prices

Investor psychology plays a big role in why stock prices show strong momentum--the tendency for prices to continue in the same direction--either rising or falling, suggests a study by Ohio State University, Columbus. "Investors tend to hold on to their losing stocks too long and sell their winners too quickly. This triggers momentum," notes assistant professor of finance Bing Han, explaining what is known as the "disposition effect."

The stock price may go down because of some bad news about the company, but many investors do not want to sell at a loss, so they hold on, hoping the price will rise later. If too many people do that, the stock price does not accurately reflect the bad news. This prompts some investors, noting that the stock is overvalued, to "short sell," betting that prices will fall. This cycle continues to push prices of the stock down, creating a momentum effect.

A similar situation occurs when a stock is rising because of good news for a company. Many investors may decide to sell the stock quickly to capture the gains before prices fall. Yet, if they sell quickly, the price may not rise to the level it should, based on the good news. This will prompt more investors to buy the stock, creating upward momentum in prices.

Most investors measure momentum by comparing a stock price today to what it was at a point in the past, such as six months or a year ago. If the price is higher now, then the stock has upward momentum; if it is lower, then the momentum is downward. However, if investors are swayed by the disposition effect, Han says the important issue would be to compare what the price is now to the price an investor paid for it--whether it was three months, one year, or 10 years ago.

"There's nothing special about a stock price six months or a year ago. Investors want to make sure that the current price is high relative to what they paid for it," Han states.

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