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Investor Psychology and Tests of Factor Pricing Models

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Author Info
Daniel, Kent (Northwestern U)
Hirshleifer, David (Ohio State U)
Subrahmanyam, Avanidhar (U of California, Los Angeles)

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Abstract

We provide a model with overconfident risk neutral investors, and therefore no risk premia, in which a price-based portfolio such as HML earns positive expected returns and loads on fundamental macroeconomic variables. Furthermore, loadings on such portfolios are proxies for mispricing and therefore forecast cross-sectional returns, even after controlling for characteristics such as book-to-market. Thus, an empirical finding that covariances incrementally predict returns does not distinguish rational factor pricing from a setting with no risk premia. The analysis reconciles the high risk (market betas) of low book-to-market firms with their low expected returns, and offers new empirical implications to distinguish alternative theories.

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Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2005-26.

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Date of creation: Nov 2005
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Handle: RePEc:ecl:ohidic:2005-26

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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Hou, Kewei & Hirshleifer, David & Teoh, Siew Hong, 2007. "The Accrual Anomaly: Risk or Mispricing?," MPRA Paper 5173, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  2. Günter Franke & Thomas Weber, 2006. "Wieweit tragen rationale Modelle in der Finanzmarktforschung?," CoFE Discussion Paper 06-09, Center of Finance and Econometrics, University of Konstanz. [Downloadable!]
  3. Hirshleifer, David & Jiang, Danling, 2007. "Commonality in Misvaluation, Equity Financing, and the Cross Section of Stock Returns," MPRA Paper 16134, University Library of Munich, Germany, revised 08 Jul 2009. [Downloadable!]
  4. Jiang, Danling, 2008. "Cross-Sectional Dispersion of Firm Valuations and Expected Stock Returns," MPRA Paper 8325, University Library of Munich, Germany. [Downloadable!]
  5. Jiang, Danling, 2006. "Investor Overreaction, Cross-Sectional Dispersion of Firm Valuations, and Expected Stock Returns," Working Paper Series 2006-8, Ohio State University, Charles A. Dice Center for Research in Financial Economics. [Downloadable!]
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