Systematic Mispricing of Speculative Stocks and the Cross-Sectional Risk-Return Trade-off

We examine the cross-section of returns from the perspective of a benchmark model that only includes systematic mispricing factors. In contrast to conclusions from standard benchmark models, we recover robust positive risk-return relations for many cross-sectional risk, distress, and friction proxies. Our findings are consistent with systematic mispricing that primarily affects speculative stocks and predominantly results in overpricing, predicting lower returns. Hence, failing to control for exposure to systematic mispricing can bias tests of risk-return trade-offs for anomalies with one speculative leg (e.g., risky, distressed, or high-friction stocks) and one nonspeculative leg. Overall, our study offers novel economic insight for this subset of anomalies, indicating that a positive risk-return trade-off can be resurrected after purging out the systematic mispricing component. The evidence suggests that a small shift in perspective generates a substantially different interpretation of the same data. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2024.08815 .