Abstract
Asymmetric information, investor optimism, and unbiased prices hypotheses are the main hypotheses proposed for explaining how investors’ difference of opinion may impact stock returns. We use a new measure for divergence in investor beliefs among sell-side analysts to test these three hypotheses. Our initial findings are not supportive of either the asymmetric information or the investor optimism hypotheses. However, since these two hypotheses predict opposing effects of divergence in opinion on stock returns, the effects could neutralize their respective impacts on stock prices. Our further empirical analysis though suggests that this is not the case. The weight of the evidence presented suggests thatwithin the sell-side, the difference of opinion does not impose a bias on future stock returns.
Highlights
W e examine three main hypotheses postulated for disentangling conflicting evidences regarding the effect of investor difference of opinion on stock prices
To study how investors’ difference of opinions might affect stock returns, we present a new difference of opinion measure based on sell-side analysts’ recommendations, using the imbalance of analysts’ upgrades and downgrades as a proxy for belief heterogeneity
The new measure is used to examine the roles of the three hypotheses in explaining divergence of opinion on stock returns, namely, the asymmetric information hypothesis, the investor optimism hypothesis, and the unbiased prices hypothesis
Summary
W e examine three main hypotheses postulated for disentangling conflicting evidences regarding the effect of investor difference of opinion on stock prices. As per the asymmetric information hypothesis, the level of difference of opinion reflects the extent of asymmetric information about firm value. This suggests an initial discount in stock valuation, and lower initial return, followed by higher return that accompanies greater risk (Varian, 1985; Merton, 1987; Doukas, Kim, & Pantzalis, 2006; Garfinkel and Sokobin, 2006). The asymmetric information hypothesis predicts lower returns followed by higher returns for stocks that investors hold different opinions. Greater difference of opinion among investors or more shorting restrictions yield more upward bias in prices, and higher initial returns. The investor optimism hypothesis predicts higher returns followed by lower returns, which contradicts the prediction of the asymmetric information hypothesis
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