UC Irvine

Theories suggest that both risk and mispricing are associated with commonality in returns, and information associated with this commonality can be used to predict future returns. However, empirically implemented factor pricing models rarely incorporate psychological factors. I propose to augment standard factor models with behavioral factors to capture commonality in mispricing caused by psychological biases. Specifically, I form risk-and-behavioral composite models and examine whether considering jointly both sources of return predictability better explains known return anomalies. I propose two behavioral factors motivated by overconfidence and limited attention, respectively, and show that behavioral factors differ from standard risk factors in several important respects. I find that the risk-and-behavioral composite models outperform both standard models and other recent models and fully explain a number of well-known anomalies, particularly growth-related anomalies. The evidence suggests that behavioral factors play a prominent role in capturing commonality in mispricing and should be incorporated into asset pricing models.