The Disposition Effect as a Determinant of the Abnormal Volume and Return Reactions to Earnings Announcements

I examine the manner in which stockholders' aggregate unrealized capital gain or loss position at the time earnings are announced affects their trading response to earnings disclosures. Contrary to predictions from rational expectations models of trade (Shackelford and Verrecchia 2002), I find that abnormal trading volume around earnings announcements is larger (smaller) when stockholders are in an aggregate unrealized capital gain (loss) position. This relation is stronger among seller-initiated trades and reverses in December, consistent with the cognitive bias referred to as the disposition effect (Shefrin and Statman 1985). I also present evidence on the consequences of the disposition effect. First, stockholders' aggregate unrealized capital gain position moderates the degree to which information-related determinants of trade (e.g. unexpected earnings, firm size, and forecast dispersion) affect abnormal announcement-window trading volume. Second, stockholders' aggregate unrealized capital gains position is associated with announcement-window abnormal returns, consistent with the disposition effect reducing the market's ability to efficiently incorporate earnings news into price.