Investor Heterogeneity And Negative Skewness In Stock Returns PDF Download

I develop and test a new theory that bridges two major pricing effects from separate literatures: (1) the negative relationship between return skewness and expected returns and (2) the negative relationship between dispersion in financial analysts' earnings forecasts and expected returns. I show that both effects arise intrinsically from market clearing of stochastic demand in a standard noisy rational expectations economy that incorporates skewed assets followed by financial analysts. In such an economy, prices that induce investors to take opposite sides of a skewed risk deviate from fundamental value on average in the direction of skewness. The magnitude of such deviations depends on investors' confidence in fundamentals. Dispersion in analysts' forecasts tends to reduce that confidence, requiring larger deviations to induce offsetting trades. Positive correlation between forecast dispersion and investor heterogeneity arises endogenously. The theory generates several novel testable predictions: (a) skewness and forecast dispersion have a joint impact on expected returns and (b) can yield negative average returns; (c) forecast dispersion has no marginal impact without skewness; (d) the skewness effect can operate without forecast dispersion; (e) higher risk or risk aversion deepens the effects; and (f) higher investor heterogeneity can weaken the effects. Consistent with the theory's implications, I show that skewness and forecast dispersion have a joint impact, yielding an average return gap of 1.61% monthly (19.3% annualized) between stocks in the 5th and 95th percentiles by skewness and dispersion. I also show that forecast dispersion has no marginal impact without skewness and that higher risk or risk aversion is associated with a deepening of their joint effect. These otherwise anomalous discoveries comprise new signicant cross-sectional features of stock returns.