Momentum and Disposition Effect in Different Market States

This study examines the relationship between momentum profits and the disposition effect across different market states, bridging two literature strands explaining momentum returns. Analyzing U.S. stock data, we find significant medium-term momentum profits when the market continues in the same direction while observing reversals during market reversals. These results align with behavioral models suggesting heightened investor overconfidence and lower risk aversion when the market continues in the same direction. More importantly, we discover that the disposition effect amplifies returns when subsequent market returns are positive. However, the disposition effect does not fully explain medium-term momentum returns when market returns remain positive, indicating a conditional interaction influenced by market dynamics. These results have practical implications for investors and fund managers, emphasizing the importance of adjusting momentum-based strategies according to market conditions and accounting for behavioral biases. By integrating the analysis of market states with behavioral factors, practitioners can enhance the performance of momentum portfolios and manage risks more effectively.