In the first chapter, I tests whether the tendency of investors to sell stocks in their portfolios that have gone up, not down, in value since purchase, known as the "disposition effect", induce under-reaction to news, leading to return predictability and a post-announcement price drift. The disposition effect implies that stock prices "under-react" to bad news when more current holders are facing a capital loss, and "under-react" to good news when more current holders are facing a capital gain. I use a database of mutual fund holdings to construct a measure of reference prices for individual stocks. Using this new measure of capital gains, I show that post-event predictability is most severe where the disposition effect predicts the biggest under-reaction. Post-event drift is larger when the news and the capital gains overhang have the same sign. The magnitude of the drift is directly related to the amount of unrealized capital gains (losses) experienced by the stock holders, prior to the event date. An event-driven equity strategy based on this effect yields monthly alphas of over 200 basis points.
The second chapter focuses on price momentum and the cross section of stock returns. I present cross sectional evidence that capital gains are a strong univariate predictor of short term returns, and appear to drive both price and earnings momentum. Once this variable is controlled for, neither past returns nor an alternative capital gains regressor constructed from past turnover has explanatory power for subsequent returns. This result provides strong evidence that the momentum anomaly is driven by disposition type effects, and that past returns are indeed a noisy proxy for unrealized capital gains experienced by the stock holders. The fact that capital gains based on holdings drive out past returns and an alternative gains variable is consistent with more precise estimates of the stock's cost basis being better predictors of stock returns.
In the third chapter (co-authored with Owen Lamont) we use mutual fund flows as a measure for individual investor sentiment for different stocks, and find that high sentiment predicts low future returns. Find flows are dumb money--by reallocating across different mutual funds, retail investors reduce their wealth in the long run. This dumb money effect is strongly positively related to the value effect. High sentiment also is associated high corporate issuance, interpretable as companies increasing the supply of shares in response to investor demand.