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A Skeptical Appraisal of Asset-Pricing Tests

  • Jonathan Lewellen
  • Stefan Nagel
  • Jay Shanken

It has become standard practice in the cross-sectional asset-pricing literature to evaluate models based on how well they explain average returns on size- and B/M-sorted portfolios, something many models seem to do remarkably well. In this paper, we review and critique the empirical methods used in the literature. We argue that asset-pricing tests are often highly misleading, in the sense that apparently strong explanatory power (high cross-sectional R2s and small pricing errors) in fact provides quite weak support for a model. We offer a number of suggestions for improving empirical tests and evidence that several proposed models don%u2019t work as well as originally advertised.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12360.

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Date of creation: Jul 2006
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Publication status: published as Lewellen, Jonathan & Nagel, Stefan & Shanken, Jay, 2010. "A skeptical appraisal of asset pricing tests," Journal of Financial Economics, Elsevier, vol. 96(2), pages 175-194, May.
Handle: RePEc:nbr:nberwo:12360
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