Is there a priced risk factor associated with conservatism?

Purpose - García Laraet al.(2011) argue that there is a conservatism-related priced risk factor in US stock returns. To put this to the test, the authors aim to analyze whether the conditional conservatism effect comes from the loading on a conditional conservatism-related factor-mimicking portfolio (systematic risk) or the conservatism characteristic itself. Design/methodology/approach - The authors form characteristic-balanced portfolios from dependent sorts of stocks on the firm’s degree of conservatism and the firm’s loading on the conservatism-related factor-mimicking portfolio as proposed by Daniel and Titman (1997) and Daviset al.(2000). Findings - The tests indicate that it is the conditional conservatism characteristic rather than the factor loading that explains the cross-sectional differences in average stock returns. Consequently, they do not find evidence for a conservatism-related priced risk factor. Originality/value - This finding suggests that investors misvalue the conservatism characteristic and casts doubt on the rational risk explanation as proposed by García Laraet al.(2011).