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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 510.

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Handle: RePEc:wop:chispw:510

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Cited by:
  1. Ravi Jagannathan & Tongshu Ma, 2002. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," NBER Working Papers 8922, National Bureau of Economic Research, Inc.
  2. Fletcher, Jonathan & Hillier, Joe, 2002. "On the usefulness of linear factor models in predicting expected returns in mean-variance analysis," International Review of Financial Analysis, Elsevier, vol. 11(4), pages 449-466.
  3. Asgharian, Hossein, 2011. "A conditional asset-pricing model with the optimal orthogonal portfolio," Journal of Banking & Finance, Elsevier, vol. 35(5), pages 1027-1040, May.
  4. Loriana Pelizzon & Massimiliano Caporin, 2012. "Market volatility, optimal portfolios and naive asset allocations," Working Papers 2012_08, Department of Economics, University of Venice "Ca' Foscari".
  5. Cesare Robotti, 2003. "Dynamic strategies, asset pricing models, and the out-of-sample performance of the tangency portfolio," Working Paper 2003-6, Federal Reserve Bank of Atlanta.
  6. Wolfgang Schmid & Taras Zabolotskyy, 2008. "On the existence of unbiased estimators for the portfolio weights obtained by maximizing the Sharpe ratio," AStA Advances in Statistical Analysis, Springer, vol. 92(1), pages 29-34, February.
  7. Luboš Pástor & Robert F. Stambaugh, 1999. "Comparing Asset Pricing Models: An Investment Perspective," CRSP working papers 497, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  8. Liu, Ludan, 2008. "It takes a model to beat a model: Volatility bounds," Journal of Empirical Finance, Elsevier, vol. 15(1), pages 80-110, January.
  9. Taras Bodnar & Wolfgang Schmid & Taras Zabolotskyy, 2009. "Statistical inference of the efficient frontier for dependent asset returns," Statistical Papers, Springer, vol. 50(3), pages 593-604, June.
  10. Tu, Jun & Zhou, Guofu, 2011. "Markowitz meets Talmud: A combination of sophisticated and naive diversification strategies," Journal of Financial Economics, Elsevier, vol. 99(1), pages 204-215, January.
  11. Asgharian, Hossein & Hansson, Bjorn, 2005. "Evaluating the importance of missing risk factors using the optimal orthogonal portfolio approach," Journal of Empirical Finance, Elsevier, vol. 12(4), pages 556-575, September.
  12. Edward J. Green & Jose A. Lopez & Zhenyu Wang, 2001. "The Federal Reserve banks' imputed cost of equity capital," Working Papers in Applied Economic Theory 2001-01, Federal Reserve Bank of San Francisco.
  13. Beaulieu, Marie-Claude & Dufour, Jean-Marie & Khalaf, Lynda, 2010. "Asset-pricing anomalies and spanning: Multivariate and multifactor tests with heavy-tailed distributions," Journal of Empirical Finance, Elsevier, vol. 17(4), pages 763-782, September.
  14. Okhrin, Yarema & Schmid, Wolfgang, 2006. "Distributional properties of portfolio weights," Journal of Econometrics, Elsevier, vol. 134(1), pages 235-256, September.
  15. Edward J. Green & Jose A. Lopez & Zhenyu Wang, 2003. "Formulating the imputed cost of equity capital for priced services at Federal Reserve banks," Economic Policy Review, Federal Reserve Bank of New York, issue Sep, pages 55-81.
  16. Goldstein, Daniel G. & Gigerenzer, Gerd, 2009. "Fast and frugal forecasting," International Journal of Forecasting, Elsevier, vol. 25(4), pages 760-772, October.
  17. MacLean, Leonard C. & Foster, Michael E. & Ziemba, William T., 2007. "Covariance complexity and rates of return on assets," Journal of Banking & Finance, Elsevier, vol. 31(11), pages 3503-3523, November.
  18. Asgharian, Hossein & Hansson, Bjorn, 2006. "Home bias among European investors from a Bayesian perspective," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 16(5), pages 397-410, December.

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