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Prospect Theory, Mental Accounting, and Momentum

  • Mark Grinblatt
  • Bing Han

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.

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File URL: http://icfpub.som.yale.edu/publications/2533
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Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number amz2533.

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Date of creation: 01 Nov 2001
Date of revision: 01 May 2007
Handle: RePEc:ysm:somwrk:amz2533
Contact details of provider: Web page: http://icf.som.yale.edu/

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