Margin trading, differences of opinion, and stock returns

We extend Miller’s (1977) divergence-of-opinion theory to the case where heterogeneous investors engage in margin trading due to their differences in sentiment. Specifically, we show that long purchasing and short selling activities due to individual investors, contribute to positive and negative mispricing respectively, thereby having negative and positive effects on subsequent stock returns. By contrast, short selling activities due to institutional investors have two opposite effects on mispricing: an information effect, which predicts a negative effect on subsequent stock returns and a price correction effect, which predicts a positive effect; the net effect will be negative if the former dominates the latter. Based on a monthly sample period for all stocks listed on the Taiwan Stock Exchange for 2006–2015, we find strong empirical evidence supporting our theoretical argument.