Stockholders’ Unrealized Returns and the Market Reaction to Financial Disclosures

• DOI: http://doi.org/10.1111/jofi.12743
• Author: ERIC WEISBROD
• Date: 01 April 2019
• Published date: 01 April 2019

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 2 •APRIL 2019

Stockholders’ Unrealized Returns and the

Market Reaction to Financial Disclosures

ERIC WEISBROD∗

ABSTRACT

Using both investor- and stock-level data, I examine the relation between stockhold-

ers’ unrealized returns since purchase and the market response to earnings announce-

ments. I demonstrate that stockholders’ unrealized gain/loss position moderates their

trading behavior in response to earnings announcements. I also find that this behav-

ior generates a short-window return underreaction to earnings news. My results are

generally consistent with predictions from prospect theory regarding the manner

in which stockholders’ unrealized returns moderate their trading response to belief

shocks. However, my results also suggest that an emotional component (i.e., regret-

avoidance/pride-seeking) is necessary to explain the observed investor behavior.

MOST ECONOMIC MODELS OF INVESTOR behavior, both rational and behavioral,

assume that investors develop beliefs about the uncertain future value of an

investment and translate those beliefs into trading decisions using some type

of preference (i.e., utility) function. Following this paradigm, a longstanding

stream of empirical research shows that investors’ trading decisions vary with

their unrealized returns since purchase (hereafter, “unrealized returns”) on

a given investment. Specifically, the disposition effect, defined as investors’

tendency to sell winners and hold losers (Shefrin and Statman (1985)), is one

of the most widely documented empirical regularities in research that examines

individual investor behavior (Barber and Odean (2013)).1The disposition effect

∗Eric Weisbrod is with the Miami Business School, University of Miami. This paper is based

on my dissertation at Arizona State University. I am grateful for the guidance provided by my

dissertation co-chairs Steve Hillegeist and Dan Dhaliwal, as well as committee members Steve

Kaplan and Mike Mikhail. I thank Kenneth Singleton (the Editor), three anonymous referees, as

well as Khrystyna Bochkay,Larry Brown, Michael Donohoe (discussant), Katharine Drake, Diana

Falsetta, Alok Kumar, Rick Laux, Andy Leone, Stan Markov, Miguel Minutti-Meza, DJ Nanda,

Sundaresh Ramnath, two anonymous JATA Conference mini-reviews, and seminar participants

at Arizona State University,UT Dallas, London Business School, The University of Miami, Singa-

pore Management University, Georgia State University, The NYU Stern School of Business, The

University of Missouri, the 2013 JATA Conference, the 2013 South Florida Accounting Research

Conference, the 2015 Florida Accounting Research Symposium, the University of Illinois–Chicago,

the U.S. Securities and Exchange Commission, and Georgetown University for helpful comments

and suggestions. I am indebted to Arwa Weisbrod for her advice and encouragement throughout

this project. I have read the Journal of Finance’s disclosure policy and have no conflict of interest

to disclose.

1The disposition effect has been documented in a variety of settings, including the trading

behavior of individual stock investors (Odean (1998), Grinblatt and Keloharju (2001), Shapira and

DOI: 10.1111/jofi.12743

899

900 The Journal of Finance R

is often cited as evidence that investors have utility or risk preferences that

depend on whether they are in a cognitive gain or loss frame of reference.2

Recently, however, preference-based explanations for the disposition effect

have been called into question. While early studies measured the disposition

effect in a binary gain/loss manner (e.g., Odean (1998)), recent studies examine

how investors’ likelihood of sale varies with the level of their unrealized returns

(Ben-David and Hirshleifer (2012), Barber and Odean (2013), An (2016)). These

studies find that investors’ selling propensity is actually a V-shaped function

of unrealized returns: selling probability increases as the magnitude of either

gains or losses increases, with the gain side having a steeper slope than the

loss side. This empirical evidence is difficult to reconcile with preference-based

explanations for the disposition effect. Accordingly, Ben-David and Hirshleifer

(2012)andAn(2016) suggest that, instead of a preference-based explanation,

speculative trading (i.e., trading based upon beliefs) may explain the disposition

effect observed in prior studies. Specifically, Ben-David and Hirshleifer (2012)

suggest that rather than stockholders’ preferences moderating their trading

decisions in response to individual shocks, stockholders’ unrealized returns

may simply be correlated with the arrival of news events that trigger belief-

based trading as unrealized returns move away from zero.

Importantly, Ben-David and Hirshleifer (2012, p. 2515) note that while

a preference-based explanation for the disposition effect implies that “other

things equal, having a loss rather than a gain reduces the probability that the

stock will be sold[,] . . . tests of the disposition effect do not hold constant other

factors influencing selling decisions that may be correlated with profit” [empha-

sis in original]. The authors go on to conclude that because no attempt is made

to control for investors’ beliefs, inferences about how investors’ preferences af-

fect their trading decisions “cannot be drawn from either the disposition effect

or our findings” (Ben-David and Hirshleifer (2012), p. 2522).

In this study, I leverage a controlled setting—the three-day window around

earnings announcements—to provide new evidence that can be used to draw in-

ferences as to how investors’ preferences affect their trading decisions. Whereas

prior studies examining the disposition effect at the investor level examine the

unconditional relation between stockholders’ unrealized returns and all of their

selling decisions, I restrict my analysis to stockholders’ trading decisions during

three-day windows centered on quarterly earnings announcements. On aver-

age, trades occurring during these announcement windows share a common

Venezia (2001)), mutual fund managers (Frazzini (2006)), professional futures traders (Coval and

Shumway (2005), Locke and Mann (2005)), and home-owners (Genesove and Mayer (2001)).

2Shefrin and Statman (1985) originally motivated the disposition effect using a four-part frame-

work that incorporates aspects of prospect theory (Kahneman and Tversky (1979)), mental account-

ing (Thaler (1985)), the emotions of regret-aversion and pride-seeking, and self-control issues. The

diminishing sensitivity feature of prospect theory is often cited as the key mechanism generating

the disposition effect, such that investors in a gain position are risk-averse and inclined to sell,

while investors in a loss position are risk-seeking and tend to hold (Li and Yang(2013)). Alternative

reference-dependent preference functions, such as realization utility, have also been proposed to

explain the disposition effect (Barberis and Xiong (2012), Ingersoll and Jin (2013), Frydman et al.

(2014)).

Stockholders’ Unrealized Returns 901

announcement-related trading motivation, and prior research identifies useful

measures of the belief shock contained in earnings news. Controlling for the be-

lief shock contained in earnings news as well as other relevant variables allows

me to isolate the marginal effect, if any, of stockholders’ unrealized returns on

their trading decisions.

Understanding the manner in which stockholders’ unrealized returns moder-

ate their announcement-window trading decisions is important because prior

studies predict that preference-driven marginal disposition effects can lead

prices to underreact to disclosed information (Frazzini (2006)) and, more gen-

erally, can generate return momentum in capital markets (Grinblatt and Han

(2005)). Accordingly,I conduct both investor- and stock-level tests to determine

whether the behavior observed in my investor-level tests aggregates to affect

stock prices.

At the investor level, I analyze the announcement-window trading decisions

of institutional fund managers. I obtain data from the commercially available

Ancerno Ltd. database, which contains the transaction histories of a sample

of institutional investors.3I use Ancerno-provided identity codes to track daily

unrealized gains and losses in individual positions taken by these fund man-

agers. Using these data, I study the shape of the marginal relation between

the fund’s unrealized return in a given stock and the fund manager’s decision

to sell during the earnings announcement window.4

Following Barber and Odean (2013), I estimate a Cox (1972) proportional

hazard rate model to analyze fund managers’ conditional selling probabilities

at various levels of returns since purchase. Importantly, my model controls

for the earnings surprise as well as a number of additional controls identified

in prior literature. I find that, estimated at the quarterly median of earnings

news, Ancerno fund managers’ selling schedule reveals a marginal disposition

effect that approximates an inverse V-shape, as predicted by recent models

based on prospect theory (Kaustia (2010), Meng (2012), Li and Yang (2013)).

Relative to the baseline hazard rate estimated for stocks with close to zero

returns (−2% to 2%), the hazard that a stock will be sold decreases with both

positive and negative returns since purchase, with a steeper decrease in the

loss domain. This generates a marginal disposition effect such that, ceteris

paribus, the hazard-of-sale for stocks that have increased from 22% to 26%

since purchase is approximately 1.24 times the hazard-of-sale of stocks that

have decreased from 22% to 26%.

Notably, however, this relation varies with earnings news. In particular,

stockholders in a gain position are more likely to sell as earnings news in-

creases, while stockholders in a loss position are less likely to sell as earnings

news increases. Given that postannouncement stock prices continue to move

3Using institutional instead of retail investor data for investor-level tests has both advantages

and limitations, which I discuss in Section I.

4I also replicate the analysis of Barber and Odean (2013) of the unconditional relation be-

tween investors’ unrealized returns since purchase and their overall selling behavior. Consistent

with prior studies that examine retail investor data, I find evidence of a V-shaped unconditional

disposition effect among Ancerno fund managers.