Can Rational Investors Overreact?

Abstract

This paper proposes a rational model to explain why asset prices can be different from fundamental values. Following Krep (1982), when uncertainties that affect asset returns accumulate into the future, intermediate trading prices will reveal more information about the states of nature than dividends. Consequently, short-term investors anticipating intermediate trading will set the price differently from the fundamental value that is calculated from future dividends, generating an (artificial) overreaction price pattern from an econometrician's point of view. The price deviation from fundamental values can lead to well-known phenomena such as the closed-end fund discount, bubbles, crashes, and excess volatility. Using dividend yield as a measure for uncertainty accumulation, the model further predicts that dividend premium generally exists but has exactly the opposite sign within firms with good or bad investment opportunities, that size and value premium are more significant for firms with zero or lower dividend yields, and that return volatility increases in book-to-market and decreases in size and dividend yield. Empirical tests have confirmed these predictions and demonstrated that mimicking portfolios of cumulative uncertainty can generate highly significant risk-adjusted returns.