LARRY SWEDROE
The 52-week high (52WH), the highest price a stock has traded for over the prior 365 days, is one of the key pieces of information communicated by the financial press. Research has found increased trading volume near the 52WH as well as subsequent price continuation (momentum). Explanations for the 52WH effect have come from the field of behavioral finance and include the disposition effect, prospect theory, attention and anchoring.
The disposition effect
The disposition effect, initially described by Hersh Shefrin and Meir Statman in their 1985 paper The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence, is the tendency to sell winning investments prematurely to lock in gains, and hold on to losing investments too long in the hope of breaking even. Standard explanations for the disposition effect—such as tax considerations, portfolio rebalancing and informed trading—have been proposed and dismissed, leaving explanations that rely on investor preferences such as prospect theory. Prospect theory implies a willingness to maintain a risky position after a loss and to liquidate a risky position after a gain. It also requires that investors derive utility as a function of gains and losses rather than the absolute level of consumption.
As Toby Moskowitz explained in his 2010 paper Explanations for the Momentum Premium, the disposition effect “creates an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its value due to premature selling or lack of buying. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell.” The disposition effect therefore creates predictability in stock returns and thus provides an explanation for the momentum premium. Further support for the disposition effect has been provided by Itzhak Ben-David and David Hirshleifer, authors of the 2010 study Are Investors Really Reluctant to Realize Their Losses? Trading Responses to Past Returns and the Disposition Effect, who found that investors sell more when they have larger gains and losses. Stocks with both larger unrealised gains and larger unrealised losses (in absolute value) will thus experience higher selling pressure. This temporarily pushes down current prices and leads to higher subsequent returns when future prices revert to their fundamental values.
More evidence on the important role played by prospect theory was provided by Nicholas Barberis, Lawrence Jin and Baolian Wang, authors of the 2019 study Prospect Theory and Stock Market Anomalies, who found that it helped explain 13 of the most prominent anomalies in finance, including momentum.
Investor attention
Studies on the role of investor attention have found that individual investors are net buyers of attention-grabbing stocks, which consequently leads to contemporaneous positive price pressure and thus lower future returns. For example, Hung Nguyen and Mia Pham, authors of the 2021 study Does Investor Attention Matter For Market Anomalies, examined the impact of investor attention on 11 stock market anomalies in U.S. markets and found that they were well explained by measures of investor attention—levels of investor attention are associated with the degree of mispricing, with anomalies being stronger following high rather than low attention periods. Their findings led them to conclude: “The results are consistent with the conjecture that too much attention allocated to irrelevant information triggers investor overreaction to information. Once the mispricing is corrected, more anomaly returns are realized following high attention periods.” Their findings were consistent with those of Jian Chen, Guohao Tang, Jiaquan Yao and Guofu Zhou, authors of the 2020 study Investor Attention and Stock Returns, who also found that investor attention helps explain anomalies. The findings on investor attention explain why individual investors are referred to as “noise traders” — they react to irrelevant information. The result, as demonstrated by Noah Stoffman, author of the 2014 study Who Trades with Whom? Individuals, Institutions, and Returns, is that when institutions and individuals engage in trade with each other, prices move, and individuals tend to be on the losing side.
Further evidence on individual investor behaviour was provided by Brad Barber and Terrance Odean, who have performed a series of studies on retail investors, including Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors and Too Many Cooks Spoil The Profits: Investment Club Performance, demonstrating that the stocks individual investors buy tend to underperform on average, and the ones they sell go on to outperform — they are the proverbial suckers at the poker table who don’t know they are the suckers.
Anchoring
Anchoring, the subconscious use of irrelevant information (such as the purchase price of a security) as a fixed reference point (or anchor) for making subsequent decisions about that security, is another well-documented cognitive investor bias and another reason individuals are referred to as noise traders. For example, market participants with an anchoring bias tend to hold investments that have gone down in price because they have anchored their fair value estimate to the higher price rather than to fundamentals. As a result, market participants assume greater risk by holding an investment in the hope the security will return to its original purchase price or previous high.
Investor attention and the 52-week high
Joshua Della Vedova, Andrew Grant and Joakim Westerholm, authors of the July 2022 study Investor Behavior at the 52-Week High, examined individual investor behaviour around the 52WH for stocks and how that behavior impacted performance. Their data sample was investor account-level data on all trades from the clearinghouse of the Nasdaq Helsinki exchange over the period 2000-2009. This dataset allowed them to classify traders as institutions or individuals and executed order types (limit order or market order), at and around the 52-week high price. That allowed them to see which party was demanding (via a market order) or supplying (via a limit order) liquidity with the corresponding trade price and quantity. Following is a summary of their findings:
- As stock prices approached the 52WH, there was an exponential increase in household selling — it increased by 21 percent when a stock was at the 52WH.
- On an average day, there was no trade imbalance between households and institutions. However, stocks within 3 percent of the 52WH exhibited a net trade imbalance of -12 percent (net sellers were households). When a stock opened at the 52WH, the net trade imbalance increased to -31 percent, representing a large-scale transfer of ownership from households to institutions.
- There was a sharp increase in the use of limit order by households when selling near the 52WH. Conditional on selling, household limit order usage rose from 50 percent of all household orders when prices were at 97 percent of the 52WH, to 59 percent of household orders when at the 52WH price, compared to a baseline of 46 percent of household orders on non-52WH day s — there was an abnormal increase in liquidity provision by households to institutional investors.
- When households were selling primarily with limit orders, returns averaged an excess of 0.7 percent over the following 90 days — in aggregate, substantial household limit order selling is a positive predictor of future returns. Stocks with high levels of limit order use by households exhibited even larger increases in returns.
- The longer the time since the 52WH, the greater the trading volume.
- While increased volatility (uncertainty) did not spark an increase in general selling, it did result in individuals using limit orders to anchor directly to the price. This finding is of interest because, during periods of uncertainty, liquidity provision tends to be more costly due to either increased spreads or higher adverse selection costs. By providing liquidity in an order book during periods of high uncertainty, individuals are adding a valuable option to other traders in the market.
Vedova, Grant and Westerholm’s findings of the negative impact of the 52WK effect on individual investors is consistent with Terrance Odean’s finding in his 1998 study, Are Investors Reluctant to Realize Their Losses?, that stocks investors sold too quickly as a result of the disposition effect continued to outperform over the subsequent periods, while the losing assets they held on to for too long remained underperformers.
The authors’ findings led them to conclude: “Overall, the results support our expectations that households suffer, in the form of post-event returns, due to their anchoring behaviour. Moreover, the post-52WH returns are intensified by household liquidity provision. The disposition effect, anchoring, and the placement of unsupervised limit orders by households allow counter-parties to open up momentum-like positions that, in turn, generate significantly higher post-52WH returns and help to explain the continual under-performance of household investors.”
Investor takeaways
The research demonstrates that the well-documented disposition effect, fuelled by investor attention, leads to an increase in the likelihood that individual investors will sell a stock as it begins to accumulate capital gains by increasing in price and that proximity to the 52-week high exacerbates the household willingness to sell to institutions. It also provides us with explanations for behavioral-based anomalies such as momentum, as well as an opportunity to better understand how our behaviours can negatively impact our results.
We cannot learn from our behavioural mistakes unless we are aware of them. Once we are aware of our biases, we can take actions to minimise the effect by setting investment goals and establishing rules (such as when to harvest losses). Having a written and signed investment plan, including a rebalancing table and defined goals, can help you avoid emotion-driven mistakes that lead to poor outcomes — the disposition effect can be de-biased. Do you have such a plan?
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® and Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-22-360
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
ALSO BY LARRY SWEDROE
Man versus machine: Do funds powered by AI outperform?
Testing the patience of value investors
New study highlights 20 years of failure for active managers
Even with index funds, look beyond the expense ratio
Identifying winning funds ex ante: Is it possible?
CONTENT FOR ADVICE FIRMS
Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.
As well as exclusive content, we also offer pre-produced videos, eGuides and articles which explain how investing works and the valuable role that a good financial adviser can play.
If you would like to find out more, why not visit the Regis Media website and YouTube channel? If you have any specific enquiries, email Robin Powell, who will be happy to help you.
© The Evidence-Based Investor MMXXII
