Charles A. Dice Center for Research in Financial Economics

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

Danling Jiang

ABSTRACT

I develop and test the theoretical predictions that when investor overreaction to market-wide news is larger, firm valuations in the cross section become more dispersed and stocks earn lower expected returns. Consistent with these predictions, measures of cross-sectional dispersion of  firm valuations are negatively related to subsequent market and portfolio excess returns, especially for sets of firms with highly subjective valuations and significant limits to arbitrage. Further, these firms underperform those with the opposite characteristics in periods when beginning-of-period firm valuation dispersion is high. In contrast, they overperform when beginning-of-period firm valuation dispersion is low.

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