Perception of Performance : A Test of Return Extrapolation in the Cross-Section

Consistent with recent findings that investors perceive performance by price changes, cross-sectional return extrapolation comes entirely from capital gains. Stocks that do not pay dividends (capital-gain stocks) experience robust return extrapolation, while dividend-paying stocks do not. Using a stock’s dividend-paying status to proxy for exposure to return extrapolation, I test cross-sectional predictions of return extrapolation models. Consistent with return extrapolation models, momentum and long-term reversal are stronger among capital-gain stocks. The value premium, however, is similar for both groups, suggesting that while return extrapolation may help generate momentum and long-term reversal, its role is limited for the value premium