The study examines whether the disposition effect, defined as the tendency of investors to ride losses and realize gains, allows return predictability and momentum in stock prices. Using French stocks quoted over the period 1995-2004, the study estimates the Grinblatt and Bing (2005) measure for unrealized capital gains (losses) based on past prices and share volume. By performing double sorts both on past one-year returns and the capital gains overhang variable, the study finds that holding past returns constant, the average returns of portfolios increase monotonically with their capital gains overhang quintile. Based on cross-sectional Fama-MacBeth (1973) regressions, the study notes that the capital gains overhang appears to be the key variable that generates the profitability of a momentum strategy. Momentum effect vanishes since this capital gains variable is considered as a regressor along with past returns and volume to expect future returns.

According to recent research, investors tend to hold assets on which they have experienced paper losses, but they are inclined to sell assets on which they have enjoyed gains. Shefrin and Statman (1985) label this evidence as the disposition effect. A combination of mental accounting (Thaler, 1985) and prospect theory (Kahneman and Tversky, 1979) is considered as the plausible explanation for this effect.

Under prospect theory of Kahneman and Tversky (1979) and Tversky and Kahneman (1992), investors behave as if maximizing an S-shaped value function. This value function is defined on the basis of gains and losses, rather than levels of wealth.

The notion of mental accounting, introduced by Thaler (1980 and 1985), is a set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. Shefrin and Statman (1985) document that investors keep a separate mental account for each stock. In that account, investors maximize an S-shaped value function, which is concave in the gains region and convex in the losses region.

Behavioral Finance Journal, International Markets, Theoretical Developments, Prospect Theory-Mental Accounting, PT-MA, International Momentum Strategies, Price Momentum, Asset Prices, Financial Markets, Cross-sectional Regressions, Market Capitalization, Return-based Momentum.