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Estimation Risk, Market Efficiency, and the Predictability of Returns

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Author Info
Jonathan Lewellen
Jay Shanken

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Abstract

In asset pricing, estimation risk refers to investor uncertainty about the parameters of the return or cashflow process. We show that with estimation risk the observable properties of prices and returns can differ significantly from the properties perceived by rational investors. In particular, parameter uncertainty will tend to induce return predictability in ways that resemble irrational mispricing, and prices can violate familiar volatility bounds when investors are rational. Cross-sectionally, expected returns deviate from the CAPM even if investors attempt to hold mean-variance efficient portfolios, and these deviations can be predictable based on past dividends and prices. In short, estimation risk can be important for characterizing and testing market efficiency.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7699.

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Date of creation: May 2000
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Handle: RePEc:nbr:nberwo:7699

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C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Bayesian Analysis
D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Marquering, W. & Verbeek, M., 2000. "The economic value of predicting stock index returns and volatility," Discussion Paper 78, Tilburg University, Center for Economic Research. [Downloadable!]
  2. Amit Goyal & Ivo Welch, 2002. "Predicting the Equity Premium With Dividend Ratios," NBER Working Papers 8788, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Marquering, W.A. & Verbeek, M.J.C.M., 2001. "The Economic Value of Predicting Stock Index Returns and Volatility," Research Paper ERS-2001-75-F&A Revision_, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni. [Downloadable!]
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