Heterogeneity of Trade and Stock Returns. Evidence from Index Fund Investors

We address the issue of how the heterogeneity of trade among investors affects stock returns. We model and test the relationship between dispersion of opinion, heterogeneity of trade and stock returns. The empirical investigation makes use of a two-year panel of more than 91 thousand individual accounts in an S&P 500 index mutual fund. We show that dispersion of opinion, proxied by the heterogeneity of trade among investors, explains part of the returns not accounted for by the fundamentals. We analytically and empirically show that the explanatory power of the dispersion of opinion increases at the very time when standard pricing models based on fundamentals fare worse.