Disposition Effect and Momentum: Modeling Irrational Behavior to Explain Apparent Momentum in Stock Prices

Grinblatt and Han (2005) model momentum using the frameworks of Prospect Theory and Mental Accounting (PT/MA). These frameworks explain the tendency of some investors to hold onto losing stocks too long and sell winning stocks prematurely, resulting in price distortions in the market which appear as momentum as market forces act to correct these discrepancies. Using stock market data provided by State Street Global Advisors (SSgA), we compare Grinblatt and Han’s model with some traditional, empirically motivated measures of momentum. We utilize the information coefficient (IC), the correlation between a model’s prediction and actual outcomes, as a metric of testing success. Although results show that the PT/MA model has some predictive power, the model does about the same, if not worse than traditional momentum measures at forecasting stock movements, leading us to conclude that PT/MA based momentum should not replace traditional measures of momentum when forecasting stock prices.