Similar Stocks

Similarity between two stocks is measured by the distance between their characteristics such as price, size, book-to-market, return on assets, and investment-to-assets. We find that after a stock's most similar stocks have experienced high (low) returns in the past month, this focal stock tends to earn an abnormally high (low) return in the current month. The long-short portfolio strategy sorted on similar-stocks' past average return earns a monthly CAPM alpha of 1.25% and a Fama-French six-factor alpha of 0.85%. This similarity effect is robust after controlling for style investing and a wide range of well-known firm-level characteristics that can predict returns in the cross section. Our result is consistent with the increased propensity for investors to buy other stocks with similar characteristics after experiencing positive returns for a currently held stock. We also explore other potential explanations for our findings.