Investor overconfidence and the security market line: New evidence from China

This paper documents a highly downward-sloping security market line (SML) in China, which is more puzzling than the typical flattened SML in the US, and does not reconcile with existing theories of the low-beta anomaly. We show that investor overconfidence offers some promises in resolving the puzzle in China: In the time series dimension, the slope of the SML becomes more inverted when investors get more overconfident. This dynamic overconfidence effect is intensified with biased self-attribution. As a general symptom of overconfidence in the cross section, high-beta stocks are also the mostly heavily traded. After accounting for trading volume, there is no longer the low-beta anomaly at both the firm and portfolio levels. Mutual fund evidence reinforces the view that institutional investors actively exploit the portfolio implications of a downward-sloping SML by shying away from high-beta stocks and betting on low-beta stocks for superior performance. (C) 2020 Elsevier B.V. All rights reserved.