What Percentage of Common Stocks are Mispriced?

Abstract

Recent empirical studies on asset pricing have generally concluded that the CAPM cannot explain the cross-sectional returns on common stocks. If stock markets are not in equilibrium, what percentage of common stocks are mispriced? Answers to this question have broad implications for market efficiency, performance evaluation, and investment strategies. To address this question, we propose a new test framework to examine the pricing of individual common stocks. The framework is based on a gain-loss asset pricing model (GLAPM), which formulates the reward of gain needed to compensate for the risk of loss under the paradigm of expected utility maximization. The GLAPM can unify the CAPM and the mean-lower partial moment models. From simulations, we show that the test framework has adequate power to reject the null hypothesis of no mispricing when it is false. Our empirical results suggest that, after properly taking into account the type-I errors, on average, no more than 1% of U.S. common stocks are mispriced during the sample period, 1948-1997. Furthermore, the GLAPM performs slightly better in explaining the gain-loss tradeoff of the sample stocks than the CAPM in explaining their mean-variance tradeoff.