ABSTRACT

This study examined the relationship between the disposition and momentum effect on equity shares in Nigeria based on the prospect theory and mental accounting. Specifically, this study was designed to assess the extent to which rising stock prices increase the sales and purchases of shares, as well as determining whether accounting information interaction with disposition effect has any relationship with the sale and purchase of stocks. To attain these objectives, research questions and hypotheses were formulated and tested. Related literature to this study were reviewed and the study used Ex post-facto research design. Data were sourced from Nigerian Stock Exchange (NSE) official publications on daily volume of shares traded, Securities and Exchange Commission (SEC), and the Nigerian Bureau of Statistics (NBS). The population of this study comprised all listed companies in Nigerian Stock Exchange as at December 31, 2014 that are current in terms of filing reports through the period(2007 to 2014). The data collected were analysed using panel data regression analysis. It was empirically determined that, positive share price Returns have a negative influence on share prices and there is no significant relationship between momentum effect and share prices in the Nigerian stock market in the period under review. The implication is that momentum is not a general feature of the Nigerian stock market, but is only apparent over certain time periods when considered on sector basis. It is recommended that when there is a progressive increase in the movements in earning per share for a period of time, companies should present their shares for sale, because it will attract the momentum traders to make investments in such companies.

CHAPTER ONE

INTRODUCTION

1.1             Background of the Study

One of the most important issues in exploring and discovering patterns and rules governing market is the way of pricing tradedsecurities. Most studies on financial issues place emphasis on active economic rationality and market efficiency. However, recent empirical research has shown that some of the behaviours of investors are in contrast with modern financial and neoclassic paradigms; therefore, researchers were faced with a lot of exceptions that were not explainable in terms of theoretical models in the form of modern financial theory or were not compatible with theories of efficient market. Therefore, a new theory called behavioural paradigm was presented to explain investors‘ behaviour (Somayeh, Vahideh, Mahdieh, & Mohammad, 2013). This was also supported by Schütte &Gregory-Smith (2015) who stated that there are an increasing number of ethically minded investors, and that, a broader shift in investment behaviour is mitigated by the attitude-behaviour gap or due to inconsistency in behaviours (Schütte & Gregory-Smith, 2015). These tendencies can be noticed in some investors holding on to their declining stocks, which is driven by prospect theory and mental accounting, and creates a spread between a stock’s fundamental value and its equilibrium price, as well

as price under-reaction to information. This spread convergence, arising from the random evolution of fundamental values and updating of reference prices, generates predictable equilibrium prices that will be interpreted as possessing momentum (Gginblatt & Bring, 2004).

However,Selling and holding decisions on stock should chiefly depend on the perceived future value of a security, but not the purchase price. This concept was captured by Disposition Effect (DE) which presents a case considered an irrational behaviour; the tendency of investors to hold losers too long and sell winners too soon, that is, investors willing to realize gains but are reluctant to realize losses. Disposition effect, which was first introduced by Shefrin &Stateman (1985), is one of the most attractive and well-documented behavioural heuristic theories among investors. It is based directly on prospect theory (kahneman &Tversky 1979) and mental accounting (Thaler 1985). Under prospect theory, investors employ an S-shaped value function to evaluate their potential gains and losses to maximize their utility. Under mental accounting, investors are more likely to assign their assets into different accounts for different stock positions, and then employ the prospect theory to keep track of financial activities. In their model, Shefrin & Stateman (1985) posit that investors maintain a separate mental account for each stock position, and are keen to maximize an S-shaped value function that is convex for losses and concave for gains.The implication of this is that investors seem to be risk-

averse in the domain of gains, whereas, in the domain of losses, they tend to be risk-seeking.

The prospect theory and mental accounting have also been used to explain the cross-sectional expected return patterns. For instance, Barberis & Huang (2001) find that the prospect theory combined with the concept of individual mental accounting, works the best in explaining the cross-sectional expected return patterns, such as the profitability of momentum strategy. Frazzini (2006) finds that prospect theory and mental accounting framework plays a leading role in explaining the cross-section of stock returns. Grinblatatt &Han (2002) also show that the prospect theory and mental accounting can explain the profitability momentum strategy or persistence in the returns of over horizons between three months and one year.

Grinblatt & Han (2002, 2005), developed a theoretical model of equilibrium prices where a group of investors have preference that combine the prospect theory with mental accounting. They suggested that investors with the disposition effect cause momentum in stock prices. That is, the demand for a stock by a prospect theory/mental accounting agent deviates from that of a fully rational investor, with the distortions being inversely related to the unrealized profit experienced on the stock. A stock that has been privy to prior good news has excess selling pressure relative to a stock that has been privy to adverse information. Such demand perturbation tends to generate a price which

under-reacts to public information. This distorts equilibrium prices relative to those predicted by standard utility theory. In equilibrium, past winners tend to be undervalued and past losers tend to be overvalued. As the above mispricing gets corrected, return predictability arises. That is, past winners will continue going up and losers will continue going down. This leads to momentum which is also well documented by Jegadeesh & Titman (1993). Grinblatt & Han‘s theoretical model (2002, 2005), further stressed that the disposition effect is estimated by using unrealized capital gain (losses) on past prices and stock turnover. The paper suggested that the unrealized capital gain variable is positively related to past returns. The unrealized capital gain is the main cause behind the profitability of a momentum strategy (investing in past winners and shorting past losers, expecting that winners will outperform losers). Moreover, the momentum effect disappears when the prospect theory and mental accounting (PT/MA) disposition effect is controlled for with a regressor which proxies for the aggregate capital gain.

1.2             Statement of Problem

Prior studies in the area on mental accounting paved way for empirical researches that explored the relation between disposition effect and stock returns. Recent empirical studies have also documented a number of irregularities in the behaviour of investors that seem to be at variance with the rational expectations paradigm. One of the most striking patterns is the

tendency of investors to sell their winners and to hold on to their losers (Somayeh, Vahideh, Mahdieh, & Mohammad, 2013). Such behaviour termed the ―disposition effect‖ by Shefrin &Statman (1985), has been uncovered in a variety of data sets and time periods.

The existence of the disposition effect seems undisputed, however there has not been an agreement among investment professionals on an explanation for this phenomenon. The empirical literature favours a behavioural explanation offered by Shefrin &Statman (1985), which combines the ideas of mental accounting (Thaler 1985) and prospect theory (Kahneman &Tversky 1979). Shefrin & Statman (1985) argue that investors keep a separate mental account for   each   stock.   Within   that   account,   investors   maximize   an   ―S‖-shaped valuation function, which is similar to a standard utility function except that it is defined on gains and losses relative to a reference point (usually the purchase price), rather than on absolute wealth. This valuation function is concave in the gains region and convex in the loss region. Thus, if a stock appreciates in price, the investor‘s wealth will be in a more risk-averse part of her valuation function, this makes a sale more likely. In contrast, if the stock is trading below its purchase price, the investor becomes risk-loving, and will hold on to the stock for a chance to break even. In addition, there are rational explanations for the disposition effect. First, portfolio rebalancing considerations suggest that investors who do not hold the market portfolio should respond to large price

increases by selling some of the shares they hold in these stocks to restore diversification (Lakonishok & Smidt 1986). Second, since transaction costs tend to be higher for lower priced stocks, and since losing investments are more likely to be lower priced, investors may refrain from selling losing investments simply to avoid the higher transaction costs (Harris 1988). Finally, disposition behaviour may result from informational differences across investors (Lakonishok & Smidt 1986).

An investor who purchased a stock on favourable information may sell it when the price goes up because she rationally believes that the stock price now reflects this information. On the other hand, if the price goes down, the investor may continue to hold it, rationally believing that her information has not yet been incorporated into the price (Lakonishok & Smidt 1986). These alternative rational explanations have been challenged by recent empirical studies. Odean (1998) argued that investors who sell their entire holdings of a stock — and who are thus unlikely to be motivated by diversification — continue to prefer selling winners. In addition, he provides evidence against the hypothesis that higher trading costs for lower priced stocks are responsible for the disposition effect. Even when differences in transaction costs are controlled, investors appear to be reluctant to realize their losses. Moreover, Odean (1998) & Brown et al. (2002) further argued that the investors‘ preference for realizing winners rather than losers does not appear to be justified by the subsequent stock

performance. Both studies find that, on average, winners that are sold, out perform over the subsequent six (6) to twenty four (24) months, losers that are not sold, which leads them to reject the information-based explanation suggested by Lakonishok &Smidt (1986).

Evidently, large majority of investors exhibit the disposition effect and they also suggest that disposition does indeed drive momentum, however, their study is based on a relatively small sample with a short time frame. (Shumway & Wu: 2006). It seems that they have not enough statistical power to estimate the relation between the disposition effect and momentum very precisely.

Moreover, most of the studies reviewed, followed Odean‘s (1998) methodology based on individual trading data and this was supported by classical researchers (Feng & Seashole 2003; Chen et al 2004; Ng & Wu 2007). Brown, Chappel Rosa, and Walter (2002), further argued that Odean methodology suffer from range of limitations. For instance they did not use aggregate market data to examine the relation between the disposition effect and momentum. It sets reference price as the average of the purchase price.. Also this approach does not consider the mental accounting theory.

More so, most work on momentum and disposition effect have not incorporated sufficient vital accounting information in their studies, hence

behavioural reaction in stock prices due to changes in accounting numbers is lacking in momentum and disposition effect literatures.

Therefore, to empirically ascertain the relation between the disposition effect and momentum effect in the Nigerian stock market based on the combined framework of prospect theory and mental accounting (PA/MA) is a very important issue because it will incorporate sufficient vital accounting information which will give more understanding to behavioural reaction in stock prices due to changes in accounting numbers and no such work has been done in Nigeria to the best of the researcher‘s knowledge.

Therefore this work is an attempt to shed light on relationship between the disposition effect and momentum effect in the Nigerian stock market using a relatively large aggregate market-wide dataset based on the combined framework of prospect theory and mental accounting.This is one of the gaps in knowledge which this work intends to fill in.

1.3             Objectives of the study

The main objective of this study is to examine the relationship between the disposition and momentum effect on equity shares in Nigerian based on the prospect theory and mental accounting. This objective is pursued through the following specific objectives:

1. To determine the extent to which rising stock prices increase the sales of shares

• To investigate the extent to which rising stock prices increase purchases of shares

• To ascertain if accounting information interaction with disposition effect has any relationship with the sale of stocks

• To determine the extent accounting information interaction with momentum effect has any relationship with the purchase of stock

1.4             Research Questions

Given the specific objectives of this study, the following research questions have been formulated to guide this study

1. To what extent do rising stock prices increase the sales of shares?

• To what extent do rising stock prices increase purchases of shares?

• How does accounting information interaction with disposition effect affect the selling of stocks?

• To what extent does accounting information interaction with momentum effect affect the purchase of stock?

1.5             Research Hypotheses

In light of the research questions formulated in this study, the following hypotheses have been formulated and stated in their null form as follows:

H₀₁: Rising stock prices are not significantly related to increase in the sales of shares.

H₀₂: Rising stock prices are not significantly related to increase in the purchases of shares

H₀₃:   Accounting  information  interacting  with  disposition  effect   has  no significant effect on the selling of shares in the Nigeria stock market

H₀₄: Accounting information interacting with momentum effect has no significant effect on the purchase of shares in the Nigeria stock market

1.6             Significance of the Study

This study will be of interest to the various stakeholders explained in the section below:

Investors: This work will be of great benefit to investors in stock market in that it will help them in proper analysis of the events of the stock market in other to know when best to sell or buy stock for maximum profitability.

Financial Advisers/Analysts: It will also help the financial advisers / analysts in that it will serve as raw materials in their financial analysis in portfolio management.

Executives Of Companies: It will help the executives of companies to know when to make its stock available for a subsequent, or follow-on, offering, so as to optimize profit because if investors are optimistic about the company‘s future they will have the tendency to trade on the stock, even in the face of stock prices declined.

Day Traders: It will be of great benefit to day traders in that it will help in providing answers to the anomalies in stock trading and improve on their forecast and predictions in the hope that their stocks will continue climbing in value for the seconds to minutes they own the stock, allowing them to lock in quick profits so as not to run into extreme risks

Emerging Countries: It has been said that there is no reliable investment risk predictive tools in emerging countries. With the expected success of this study and taking into account the local environments, it is believed that other emerging countries will adopt the tools in their risk assessment process.

Government: The Nigerian stock market is classified as one of the world‘s emerging markets hence; information from this study may assist in repositioning the market.

Stock Market Authority: This group might find the results helpful in avoiding any unexpected market catastrophe, controlling market strategies, improving the stock market industry, and assessing the degree to which the stock market may need to be reformed.

Researchers: This research contributes to existing financial knowledge, especially in the area of understanding the relationship between mental accounting analysis of disposition and momentum effect in Nigerian stock market. This study also contributes to a new research direction for future researchers.

1.7             Scope of Study

This study is entirely centred on identifying the anomaly discovered in behavioural Accounting/finance; the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value. To this end, time series data covering the period from 2007-2014wasadopted. This base period of 2007 was chosen because that was the period of the great decline in the capital market. The data consist of the Nigerian Stock Exchange (NSE) official publication on daily volume of shares traded, data from the
Securities and Exchange Commission (SEC), Nigerian Stock Exchange (NSE) and the Nigerian Bureau of Statistics (NBS).

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