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Asset Pricing Models: Implications for Expected Returns and Portfolio Selection

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  • A. Craig MacKinlay
  • Lubos Pastor

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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Suggested Citation

  • A. Craig MacKinlay & Lubos Pastor, "undated". "Asset Pricing Models: Implications for Expected Returns and Portfolio Selection," Rodney L. White Center for Financial Research Working Papers 13-99, Wharton School Rodney L. White Center for Financial Research.
  • Handle: RePEc:fth:pennfi:13-99
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    File URL: http://finance.wharton.upenn.edu/%7Erlwctr/papers/9913.pdf
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