Two Channels, One Anomaly: Diagnosing the Investment Effect

Abstract: The investment effect is driven by Zhang's rational direct discount-rate channel in the short term but by a non-rational indirect profitability channel in the long term. Unifying Zhang's production based asset pricing with Bordalo et al.'s diagnostic expectations framework into the Diagnostic Investment CAPM, a psychological- and production- based theoretical model, I explain the investment effect from both a rational and a mispricing perspective. Studying analysts' reaction to investment shocks, I show that analysts do exhibit diagnosticity with regards to investment and systematically overreact to the profitability information contained in investment-level variations, creating a second channel for the investment effect when prices correct.