Disentangling Anomalies: Risk Versus Mispricing

Abstract

Systematic mispricing primarily affects speculative stocks and predominantly results in overpricing, predicting lower average returns. Because speculative stocks overlap with stocks deemed risky by rational models, failing to control for exposure to systematic mispricing can bias tests of risk-return tradeoffs. Controlling for systematic mispricing, we recover robust positive risk-return relations for many cross-sectional risk proxies, including low-risk and distress anomalies. We also recover robust positive illiquidity- return relations. We provide a unifying framework explaining numerous puzzles arising from empirical failures of standard pricing models, and show empirical risk-return relations supporting rational models can be recovered by accounting for time-varying common mispricing.

Keywords: systematic risk, anomalies, mispricing, sentiment, beta, illiquidity, low-risk anomalies, distress

JEL Classification: G12, G14, D84