Capital Gains Overhang with a Dynamic Reference Point (with B Summers & D Duxbury)
Management Science, Volume 66, Issue 10 (October 2020)
Abstract: Financial models incorporating a reference point, such as the Capital Gains Overhang (CGO) model, typically assume it is fixed at the purchase price. Combining experimental and market data, this paper examines whether such models can be improved by incorporating reference point adjustment. Using real stock prices over horizons from 6-months to 5-years, experimental evidence demonstrates that a number of salient points in the prior share price path are key determinants of the reference point, in addition to the purchase price. Market data testing is then undertaken using the CGO model. We show that composite CGO variables, created using a mix of salient points with weights determined in the experiment, have greater predictive power than the traditional CGO variable in both cross-sectional US equity return analysis and when analyzing the performance of double-sorted portfolios. In addition, future trading volume is more sensitive to changes in the composite CGO variables than to the traditional CGO, further emphasizing the importance of adjusting reference points.
The Impact of Attention and Trading Frequency on Sequential Reference Point Adaptation (with D Duxbury)
Working Paper
Abstract: We investigate sequential reference point adaptation through an experiment that tracks monthly adjustments over five-year stock price charts. Unlike prior studies relying on single estimates, our sequential approach shows that reference points update in response to recent price changes and are influenced by initial purchase and current prices. Adaptation notably intensifies under sequential elicitation and is asymmetric, stronger after gains than losses. Higher-frequency traders, who more closely monitor price movements, also exhibit greater reference point adaptation. Overall, the results are consistent with an association between attention and reference-point updating, and may explain heterogeneity in biases such as the disposition effect.
Shareholder-Weighted Returns and Stock Return Predictability
Working Paper
Abstract: We ask whether weighting a stock's return path by its current shareholder base captures information about future returns that price-only measures overlook. Using daily volume to reconstruct the current shareholder base, we estimate three intuitive signals from each stock's return path: a cumulative return that reflects what current holders actually earn, an average return that captures the typical daily experience of holding the stock, and a scale-invariant gain-loss ratio that records the share of shareholders who are in profit. The shareholder-weighted variables forecast future returns, subsume capital gains overhang, and complement classic momentum. Evidence from portfolio sorts and cross-sectional regressions remains strong after controlling for standard factors and across various exchanges, price segments, and time periods. The results indicate that the way investors perceive their gains affects their future behavior and subsequent returns.
Decomposing Unrealized Returns into Adapted and Unadapted Components Using Reference Points (with D Duxbury)
Working Paper
Abstract: Previous research shows that realized and unrealized outcomes influence subsequent risk-taking behavior, albeit in opposite ways. We further decompose unrealized outcomes into adapted and unadapted components, which have distinct implications for risk-taking. Adapted returns are internalized as individuals adjust their reference point, while unadapted returns remain externalized. Our empirical evidence shows that adapted and unadapted returns exert opposing influences on future stock returns. Notably, the highest-performing stocks have a distant past return that is low (reflecting an adapted loss) paired with a recent past return that is high (reflecting an unadapted gain).
New Project: Distorted Returns- The Influence of Linear Scales (with B Summers)