Asset Pricing Models: Implications for Expected Returns and Portfolio Selection
A. Craig Mackinlay
University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)
University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
NBER Working Paper No. w7162
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.
Number of Pages in PDF File: 41working papers series
Date posted: July 12, 2000
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