Cross-Sectional Return Dispersion and the Equity Premium
42 Pages Posted: 14 Mar 2012 Last revised: 7 Sep 2015
Date Written: August 27, 2015
In this paper, I examine whether stock return dispersion (RD) provides useful information about future stock returns. RD consistently forecasts a decline in the excess market return at multiple horizons, and compares favorably with alternative predictors used in the literature. The out-of-sample performance of RD tends to beat the alternative predictors, and is economically significant as indicated by the certainty equivalent gain associated with a trading investment strategy. RD has greater forecasting power for big and growth stocks compared to small and value stocks, respectively. I discuss a theoretical mechanism giving rise to the negative correlation between RD and the equity premium.
Keywords: asset pricing, stock return dispersion, cross-sectional variance of stock returns, predictability of stock returns, out-of-sample predictability
JEL Classification: G12, G14, G17
Suggested Citation: Suggested Citation