Overconfidence, Arbitrage, and Equilibrium Asset Pricing


  • Kent D. Daniel,

  • David Hirshleifer,

  • Avanidhar Subrahmanyam

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    • Daniel is at the Kellogg School, Northwestern University; Hirshleifer is at the Fisher College of Business, The Ohio State University; Subrahmanyam is at the Anderson Graduate School of Management, University of California at Los Angeles. We thank the anonymous referees, Jonathan Berk, Michael Brennan, Wayne Ferson, Bob Jones, Gautam Kaul, Blake LeBaron, Simon Gervais, Rick Green, Terry Odean, Canice Prendergast, Tyler Shumway, Matt Spiegel, the editor, René Stulz, Siew Hong Teoh, Sheridan Titman, Ingrid Werner, and seminar participants at Arizona State, Boston College, Carnegie Mellon University, Cornell University, Dartmouth College, Emory University, Hong Kong University of Science and Technology, INSEAD, London School of Economics, MIT, University of North Carolina, NYU, Ohio State University, Princeton University, Stockholm School of Economics, USC, Vanderbilt University, and University of Virginia for helpful comments and discussions. This paper was presented at the 1998 Econometric Society Meetings in Chicago, the 1998 conference on behavioral finance at Yale, the 1998 conference on efficient markets at UCLA, the 1998 Berkeley Program in Finance at Santa Barbara, the NBER 1998 Asset Pricing Meetings in Chicago, and the 1999 WFA meetings. Hirshleifer thanks the Nippon Telephone and Telegraph Program of Asian Finance and Economics for financial support.


This paper offers a model in which asset prices reflect both covariance risk and misperceptions of firms' prospects, and in which arbitrageurs trade against mispricing. In equilibrium, expected returns are linearly related to both risk and mispricing measures (e.g., fundamental/price ratios). With many securities, mispricing of idiosyncratic value components diminishes but systematic mispricing does not. The theory offers untested empirical implications about volume, volatility, fundamental/price ratios, and mean returns, and is consistent with several empirical findings. These include the ability of fundamental/price ratios and market value to forecast returns, and the domination of beta by these variables in some studies.