A Simple Explanation for the Dispersion Anomaly
49 Pages Posted: 1 Oct 2017 Last revised: 21 Mar 2018
Date Written: March 18, 2018
We explain the dispersion anomaly, the tendency of stocks with high analyst forecast dispersion to produce lower future returns, by testing the implied assumption that analysts' bias is distributed equally when portfolios are sorted by dispersion (Johnson, 2004). We find that analysts' bias is not symmetrically distributed across dispersion groups. High dispersion firms contain forecasts that are too optimistic, but the over optimism in low dispersion firms is much less. Given the well-known tendency of analysts to walk-down their forecasts over the fiscal year, this asymmetry produces future negative forecast revisions for the high dispersion firms. These negative cash flow shocks are sufficient to completely explain the dispersion anomaly. Removing the forecast bias component from dispersion produces a conditional dispersion measure that positively predicts returns, suggesting a positive risk premium to differences of opinion in equities.
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