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Rationally Neglected Stocks

There are large cross-sectional differences in the probability and magnitude of mispricing among stocks. Mispricing is traditionally attributed to stock-specific frictions. We show that mispricing can be explained in a rational equilibrium where investors allocate investigative resources to stocks to maximize their expected profits from arbitrage. Stocks with smaller dollar profit potential are allocated less attention and their percentage mispricing is higher on average. For such stocks, information discovery by investors is slow and the mispricing is corrected mostly through mandatory disclosures by firms. Using measures of institutional attention and trading discreteness, we confirm this mechanism empirically. The attention allocation channel explains the cross-sectional pattern of mispricing better than any classic arbitrage frictions.