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Asset Pricing Models: Implications for Expected Returns and Portfolio Selection

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  • A. CRAIG MacKINLAY
  • LUBOŠ PÁSTOR

Abstract

Implications of factor-based asset pricing models for estimation of expected returns and for portfolio selection are investigated. In the presence of model mispricing due to a missing risk factor, the mispricing and the residual covariance matrix are linked together. Imposing a strong form of this link leads to expected return estimates that are more precise and more stable over time than unrestricted estimates. Optimal portfolio weights that incorporate the link when no factors are observable are proportional to expected return estimates, effectively using an identity matrix as a covariance matrix. The resulting portfolios perform well both in simulations and in out-of-sample comparisons.

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Paper provided by Center for Research in Security Prices, Graduate School of Business, University of Chicago in its series CRSP working papers with number 362.

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Handle: RePEc:wop:chispw:362

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  7. repec:fth:pennfi:72 is not listed on IDEAS
  8. Jorion, Philippe, 1986. "Bayes-Stein Estimation for Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(03), pages 279-292, September.
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