Predictability in the cross-section of returns has fueled much of the market efficiency debate. Whether such predictability is due to mismeasurement of risk or constitutes an efficient market “anomaly” remains unresolved, due in large part to the joint hypothesis problem. Complicating this debate, however, is the fact that traditional asset pricing theory assumes markets are friction less and complete and investors are well-diversified, yet ample empirical evidence demonstrates the existence of sizeable market frictions and large groups of poorly diversified investors. We argue and show that accounting for these features of the market critically aids our understanding of the cross section of returns.

Rather than focus on a particular friction in the market, or a particular set of poorly diversified investors, we examine the characteristics of firms most likely to suffer from frictions in the economy and/or have concentrated investor bases. Specifically, we characterize how affected a firm is from market frictions by the level of “delay” in its share price. Firms whose stock prices respond sluggishly to market information are those most likely facing the most severe frictions.