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Capital Gains Overhang with a Dynamic Reference Point

Author

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  • Christopher Riley

    (University of Leicester School of Business, Leicester LE2 1RQ, United Kingdom;)

  • Barbara Summers

    (Centre for Decision Research, Leeds University Business School, Leeds LS2 9JT, United Kingdom;)

  • Darren Duxbury

    (Newcastle University Business School, Newcastle Upon Tyne NE1 4SE, United Kingdom)

Abstract

Financial models incorporating a reference point, such as the Capital Gains Overhang (CGO) model, typically assume it is fixed at the purchase price. Combining experimental and market data, this paper examines whether such models can be improved by incorporating reference-point adjustment. Using real stock prices over horizons from 6 months to 5 years, experimental evidence demonstrates that a number of salient points in the prior share price path are key determinants of the reference point, in addition to the purchase price. Market data testing is then undertaken by using the CGO model. We show that composite CGO variables, created by using a mix of salient points with weights determined in the experiment, have greater predictive power than the traditional CGO variable in both cross-sectional U.S. equity-return analysis and when analyzing the performance of double-sorted portfolios. In addition, future trading volume is more sensitive to changes in the composite CGO variables than to the traditional CGO, further emphasizing the importance of adjusting reference points.

Suggested Citation

  • Christopher Riley & Barbara Summers & Darren Duxbury, 2020. "Capital Gains Overhang with a Dynamic Reference Point," Management Science, INFORMS, vol. 66(10), pages 4726-4745, October.
    • Handle: RePEc:inm:ormnsc:v:66:y:2020:i:10:p:4726-4745
    DOI: 10.1287/mnsc.2019.3404
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    4. Tianyang Wang & Robert G. Schwebach & Sriram V. Villupuram, 2022. "Reference point formation: Does the market whisper in the background?," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 45(2), pages 384-421, June.

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