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Asset Pricing Models: Implications for Expected Returns and Portfolio Selection

  • A. Craig MacKinlay
  • Lubos Pastor

When a risk factor is missing from an asset pricing model, the resulting mispricing is embedded within the residual covariance matrix. Exploiting this phenomenon leads to expected return estimates that are more stable and precise than estimates delivered by standard methods. Portfolio selection can also be improved. At an extreme, optimal portfolio weights are proportional to expected returns when no factors are observable. We find that such portfolios perform well in simulations and in out-of-sample comparisons. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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Paper provided by Wharton School Rodney L. White Center for Financial Research in its series Rodney L. White Center for Financial Research Working Papers with number 13-99.

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Handle: RePEc:fth:pennfi:13-99
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  1. Jorion, Philippe, 1991. "Bayesian and CAPM estimators of the means: Implications for portfolio selection," Journal of Banking & Finance, Elsevier, vol. 15(3), pages 717-727, June.
  2. Grinblatt, Mark & Titman, Sheridan, 1987. "The Relation between Mean-Variance Efficiency and Arbitrage Pricing," The Journal of Business, University of Chicago Press, vol. 60(1), pages 97-112, January.
  3. Lakonishok, Josef & Shleifer, Andrei & Vishny, Robert W, 1994. " Contrarian Investment, Extrapolation, and Risk," Journal of Finance, American Finance Association, vol. 49(5), pages 1541-78, December.
  4. Kent Daniel & Sheridan Titman, 1996. "Evidence on the Characteristics of Cross Sectional Variation in Stock Returns," NBER Working Papers 5604, National Bureau of Economic Research, Inc.
  5. 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.
  6. Lubos Pástor & Robert F. Stambaugh, . "Costs of Equity Capital and Model Mispricing," Rodney L. White Center for Financial Research Working Papers 4-98, Wharton School Rodney L. White Center for Financial Research.
  7. Huberman, Gur & Kandel, Shmuel & Stambaugh, Robert F, 1987. " Mimicking Portfolios and Exact Arbitrage Pricing," Journal of Finance, American Finance Association, vol. 42(1), pages 1-9, March.
  8. Dickinson, J. P., 1974. "The Reliability of Estimation Procedures in Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 9(03), pages 447-462, June.
  9. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  10. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December.
  11. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, vol. 57(5), pages 1121-52, September.
  12. Green, Richard C & Hollifield, Burton, 1992. " When Will Mean-Variance Efficient Portfolios Be Well Diversified?," Journal of Finance, American Finance Association, vol. 47(5), pages 1785-809, December.
  13. Connor, Gregory & Korajczyk, Robert A., 1986. "Performance measurement with the arbitrage pricing theory : A new framework for analysis," Journal of Financial Economics, Elsevier, vol. 15(3), pages 373-394, March.
  14. Huberman, Gur & Kandel, Shmuel, 1987. " Mean-Variance Spanning," Journal of Finance, American Finance Association, vol. 42(4), pages 873-88, September.
  15. repec:fth:pennfi:72 is not listed on IDEAS
  16. Roll, Richard & Ross, Stephen A, 1980. " An Empirical Investigation of the Arbitrage Pricing Theory," Journal of Finance, American Finance Association, vol. 35(5), pages 1073-1103, December.
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