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STRATEGIES
Why the Market's Winners Tend to Keep Winning
By MARK HULBERT


NEW study helps solve the mystery of why stock prices tend to exhibit momentum.

Many investors have been familiar with the idea of stock momentum since at least the early 1990's. That was when academic studies started showing that stocks that had risen the most over a six-month period, on average, outperformed the market for an additional 6 to 12 months — and that stocks whose prices had declined the most tended to continue lagging behind. But many researchers have been frustrated by the lack of a good explanation for the trend.

In a recent study, however, two finance professors, Mark S. Grinblatt, of the University of California at Los Angeles, and Bing Han, now of the University of Calgary in Alberta, demonstrate that momentum exists because of investors' tendency to sell their winners more rapidly than their losers. The research, which has been circulating in academic circles for several months, is online at http://papers.ssrn.com/sol3/papers
.cfm?abstract-id=288466.

Psychologists have long known that because people hate to acknowledge mistakes, they tend to hold on to losing stocks longer than they keep winners, a tendency known as the disposition effect. In their study, Professor Grinblatt and Professor Han linked the idea to momentum. They concluded that the disposition effect slows the pace of investor reaction to new information.

Consider a company whose stock price rises in response to good news. This increases the number of investors who hold the stock at a profit, which leads to an increase in the proportion of owners who have an above-average predisposition to sell. The increased selling pressure puts a damper on the stock's reaction to the good news.

A similar process occurs when a company reports bad news. As its stock declines, the number of investors who hold it at a loss starts to climb. Because these investors are relatively reluctant to sell a stock when it is down, the pressure on the stock will decline, mitigating the fall in its share price.

This period of underreaction, however, doesn't last forever. The underreaction, for example, prompts new investors to buy stocks whose prices have not fully incorporated the good news or to sell short issues that have not fully reflected the bad news. This buying and selling tends to cause these stocks to continue in the direction in which they first moved on the news — creating price momentum.

To measure the impact of the disposition effect, the professors estimated investors' total unrealized gains in each stock. They devised a complex model that considered not only the difference between a stock's level and its price on all trading days over the previous five years, but also its daily trading volume. They studied all stocks on the New York and American stock exchanges from July 1962 to December 1996.

The professors found that their gauge of unrealized gains provided more accurate forecasts of which stocks would outperform the market than the measurements traditionally used by momentum investors: the direction and magnitude of a stock's recent price changes. Among stocks whose prices increased at equal rates over the previous six months, those whose investors had the largest total unrealized gains performed better, on average, over the next year.


PUTTING this research into practice is easier said than done, because the professors' model for calculating total unrealized gains is so complex. But momentum investors can take advantage of the research by focusing on how often investors trade in a stock. Investors who hold a stock for a long time are likely to have more unrealized capital gains or losses than investors who trade often in that stock.

Given two stocks whose prices have been rising, momentum investors should pick the one in which there has been less trading, as suggested by the ratio of trading volume to shares outstanding.