Can the Representativeness Heuristic Explain the Asset Growth Anomaly?

54 Pages Posted: 28 Jan 2021

See all articles by Miao He

Miao He

Tulane University, A.B. Freeman School of Business

Nishad Kapadia

Tulane University - Finance & Economics

Sheri Tice

Tulane University - A.B. Freeman School of Business

Date Written: August 25, 2020

Abstract

We find that the low average returns to firms with high asset growth are consistent with two key implications of models of diagnostic investor expectations (e.g., Bordalo, Gennaioli, La Porta, and Shleifer, 2019) that formalize the representativeness heuristic of Kahneman and Tversky (1972). These models predict that investors overestimate the subjective probability of states that are more representative of a firm’s type and also neglect risk after a string of good news. We construct a measure of how representative the stereotype the ‘next Google’ is of high asset growth in the recent past. We show that this measure predicts the returns of CMA, the asset growth factor in the five factor model of Fama and French (2015). Returns to CMA are 17.5% over the 3 years after months with high representativeness and only 5.4% following low representativeness months. In the cross-section, we find evidence consistent with investors neglecting the risk of high asset growth firms. The asset growth effect is not present in portfolios with low distress risk and the interaction between distress and asset growth, rather than asset growth by itself, predicts low returns in Fama and MacBeth (1973) regressions and portfolio sorts. We also find that analysts and markets do not appreciate the importance of the interaction between asset growth and distress and are sluggish in responding to news for the ‘interaction’ portfolio. Finally, we show that our measure of representativeness predicts the returns of the interaction portfolio.

Keywords: Cross section of expected returns, Asset Growth, Representativeness

JEL Classification: G12, G4

Suggested Citation

He, Miao and Kapadia, Nishad and Tice, Sheri, Can the Representativeness Heuristic Explain the Asset Growth Anomaly? (August 25, 2020). Available at SSRN: https://ssrn.com/abstract=3739972 or http://dx.doi.org/10.2139/ssrn.3739972

Miao He

Tulane University, A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA
United States
5046075921 (Phone)

Nishad Kapadia (Contact Author)

Tulane University - Finance & Economics ( email )

A.B. Freeman School of Business
7 McAlister Drive
New Orleans, LA 70118
United States
504-314-7454 (Phone)

Sheri Tice

Tulane University - A.B. Freeman School of Business ( email )

A.B. Freeman School of Business
7 McAlister Drive
New Orleans, LA 70118
United States
504-865-5469 (Phone)
504-865-6751 (Fax)

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