Investor Psychology and Tests of Factor Pricing Models

Kent Daniel, David Hirshleifer and Avanidhar Subrahmanyam
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Avanidhar Subrahmanyam: U of California, Los Angeles

Working Paper Series from Ohio State University, Charles A. Dice Center for Research in Financial Economics

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.

Date: 2005-11
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Citations: View citations in EconPapers (19)

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