Investor sentiment, limits to arbitrage, and hard-to-value stocks

An uninformed demand shock driven by investor sentiment and limits on arbitrage jointly result in the mispricing of hard-to-value stocks in standard behavioral models. However, existing work focuses on investigating the mispricing effect of either investor sentiment or limits to arbitrage possibly due to the difficulty of empirically distinguishing proxies for limits to arbitrage from hard-to-value proxies, while assuming the other is given. This paper explicitly investigates the joint and distinct roles of investor sentiment and limits to arbitrage in the mispricing effect simultaneously in a unified empirical framework. Our results show that the existence and magnitude of a mispricing depend on whether these two factors, i.e., investor sentiment and limits to arbitrage, reinforce or undermine each other. We emphasize that both investor sentiment and limits to arbitrage are two necessary conditions for a mispricing in an empirical setting.