In this paper, we infer how the estimates of firm value by “optimists” and “pessimists” evolve in response to information shocks. Specifically, we examine returns and disagreement measures for portfolios of short-sale-constrained stocks that have experienced large gains or large losses. Our analysis suggests the presence of two groups, one of which overreacts to new information and remains biased over about 5 years, and a second group, which underreacts and whose expectations are unbiased after about 1 year. Our results have implications for the belief dynamics that underlie the momentum and long-term reversal effect.

A common practice in the finance literature is to create characteristic portfolios by sorting on characteristics associated with average returns. We show that the resultant portfolios are likely to capture not only the priced risk associated with the characteristic but also unpriced risk. We develop a procedure to remove this unpriced risk using covariance information estimated from past returns. We apply our methodology to the five Fama-French characteristic portfolios. The squared Sharpe ratio of the optimal combination of the resultant characteristic-efficient portfolios is 2.13, compared with 1.17 for the original characteristic portfolios.

We propose a theoretically motivated factor model based on investor psychology and assess its ability to explain the cross-section of U.S. equity returns. Our factor model augments the market factor with two factors that capture long- and short-horizon mispricing. The long-horizon factor exploits the information in managers’ decisions to issue or repurchase equity in response to persistent mispricing. The short-horizon earnings surprise factor, which is motivated by investor inattention and evidence of short-horizon underreaction, captures short-horizon anomalies. This 3-factor risk-and-behavioral model outperforms other proposed models in explaining a broad range of return anomalies.