Investor Psychology and Misvaluation Comovement

Abstract

In this paper we measure stock misvaluation following Rhodes-Kropf et al. (2005) and examine its relation to stock returns. We find that the misvaluation measure has incremental explanatory power for future returns over size, book-to-market ratio, momentum, and the share issuance effect. Based on the misvaluation measure, we form a misvaluation factor by longing undervalued stocks and shorting overvalued stocks, and find that stock covariances with this factor predict future returns. The properties of stocks with different degrees of misvaluation are investigated, and the evidence is consistent with the argument that stock misvaluation is caused by investor overreaction. Lastly, we show that the negative relation between idiosyncratic risk and return documented by Ang et al. (2006, 2009) is conditional on stock misvaluation.