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R2 and Price Inefficiency

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Author Info
Hou, Kewei (Ohio State U)
Peng, Lin (Baruch College, City U of New York)
Xiong, Wei (Princeton U)
Abstract

Motivated by the recent debate on return R2 as an information-efficiency measure, this paper proposes and examines a new hypothesis that R2 is related to investors’ biases in processing information. We provide a model to show that R2 decreases with the degree of the marginal investor’s overreaction to firm-specific information. This theoretical result motivates an empirical hypothesis that stocks with lower R2 should exhibit more pronounced overreaction-driven price momentum. Empirically, we confirm that such a negative relationship between R2 and price momentum exists, and find this relationship robust to controls for risk as well as several alternative mechanisms, such as slow information diffusion, information uncertainty, fundamental R2 and illiquidity. Furthermore, we also document stronger long-run price reversals for stocks with lower R2. Taken together, our results suggest that return R2 could be related to price inefficiency.

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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 2006-23.

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Date of creation: Nov 2006
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Handle: RePEc:ecl:ohidic:2006-23

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