Hersh SheErin and Meir

S ize and book-to-market ratios have emerged as the two prominent variables that are significantly related to stock returns. Fama and French [1992] find that stock returns are negatively related to size and positively related to book-to-market ratios. They also find that the relationship between stock returns and beta is not statistically significant. The Fama and French research caps earlier studies that reveal strong relationships among stock returns, size, and book-to-market ratios (Banz [1981], Reinganum [1981], Stattman [1980], and Rosenberg, Reid, and Lanstein [1985]). It also follows earlier studies that reveal a weak relationship between stock returns and beta (Levy [1978] and Lakonishok and Shapiro [1986]). Fama and French divide the set of theories into two contexts within which the empirical results can be viewed, one related to rational valuation and the other related to overreaction. The essence of the rational valuation theory is that size and book-to-market are indicators of risk through their relationship with the economic prospects of com~es. The essence of overreaction, as described by De Bondt and Thaler [1985], is that investors overreact o recent stock returns, thereby causing the stocks of "losers" to become undervalued and the stocks of "winners" to become overvalued. Fama and French lean toward the rational valuation theory; Fama and French's analysis has been challenged on several grounds. Chan and Lakonishok [1993] emphasize that the relationship between returns and beta must be interpreted with caution because realized HERSH SHEFRIN and MEIR