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Investor Psychology and Tests of Factor Pricing Models

  • Daniel, Kent

    (Northwestern U)

  • Hirshleifer, David

    (Ohio State U)

  • Subrahmanyam, Avanidhar

    (U of California, Los Angeles)

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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File URL: http://www.cob.ohio-state.edu/fin/dice/papers/2005/2005-26.pdf
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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
Contact details of provider: Phone: (614) 292-8449
Web page: http://www.cob.ohio-state.edu/fin/dice/list.htmEmail:


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