Investor Overreaction, Cross-Sectional Dispersion of Firm Valuations, and Expected Stock Returns

Abstract

This paper develops the theoretical predictions that when investor overreaction to market-wide information is larger, firm valuations in the cross-section become more dispersed, and stocks on average earn lower expected returns. Consistent with the model prediction, I find that my measure of firm valuation dispersion measure is a negative predictor of subsequent aggregate returns. The dispersion-return relation is most pronounced among firms that have highly subjective valuations and significant limits of arbitrage.

Keywords: Overreaction, overconfidence, aggregate, cross-section, arbitrage

JEL Classification: G12, G14