The Disposition Effect and Momentum

We examine how the disposition effect, an empirically documented bias in investor behavior, affects market prices. We show that the disposition effect can help explain positive autocorrelation of returns, i.e. the momentum effect. Our model explains the strong seasonality in momentum profits and is consistent with other empirical regularities of momentum profits. In contrast to other recent work, our momentum result does not rely on biases in the expectation of fundamentals. It is consequently independent of whether price changes are driven by news about fundamentals or something else (price bubbles, noise) and it is consistent with prices over- or underreacting to news about fundamentals.