Rationally Mispriced Stocks

Abstract

We describe a theoretical mechanism that determines how mispricing is distributed in the cross-section of stocks in equilibrium. This mechanism does not involve common frictions that limit arbitrage but is entirely based on the rational allocation of information acquisition resources by professional investors. Our main results are that mispricing not eliminated by arbitrage trading is greater in smaller stocks and that capital constrained investors find it optimal to self-select into small-cap styles. Our empirical investigation of institutional trading, portfolios, and information acquisition activities confirms these predictions. In the cross-section of stocks, size tends to explain mispricing better than any explicitly measured friction, suggesting that most of the variation in mispricing can be attributed to a rational channel.

Keywords: mispricing, information discovery, institutional trading

JEL Classification: G11, G14