Can idiosyncratic risk explain the relation between reinvested earnings and future abnormal stock returns?

Abstract

This paper examines whether idiosyncratic risk can explain mispricing of reinvested earnings. My empirical result shows that the negative relation between reinvested earnings and future abnormal stock returns documented by Dechow, Richardson, and Sloan (2008) is more prevalent in higher idiosyncratic risk firms. This suggests that idiosyncratic risk prevents arbitragers from eliminating mispricing of reinvested earnings. My finding also suggests that when idiosyncratic risk is controlled, the effectiveness of reinvested earnings-based trading strategy does not increase in the earnings response coefficients, which is not consistent with the earnings fixation hypothesis. This can provide insights in explaining mispricing of reinvested earnings as well as accruals.