Estimation Risk, Market Efficiency, and the Predictability of Returns

53 Pages Posted: 17 May 2000 Last revised: 17 Oct 2010

See all articles by Jonathan Lewellen

Jonathan Lewellen

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER)

Jay A. Shanken

Emory University - Goizueta Business School; National Bureau of Economic Research (NBER)

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Date Written: May 2000

Abstract

In asset pricing, estimation risk refers to investor uncertainty about the parameters of the return or cashflow process. We show that with estimation risk the observable properties of prices and returns can differ significantly from the properties perceived by rational investors. In particular, parameter uncertainty will tend to induce return predictability in ways that resemble irrational mispricing, and prices can violate familiar volatility bounds when investors are rational. Cross-sectionally, expected returns deviate from the CAPM even if investors attempt to hold mean-variance efficient portfolios, and these deviations can be predictable based on past dividends and prices. In short, estimation risk can be important for characterizing and testing market efficiency.

Suggested Citation

Lewellen, Jonathan W. and Shanken, Jay A., Estimation Risk, Market Efficiency, and the Predictability of Returns (May 2000). NBER Working Paper No. w7699, Available at SSRN: https://ssrn.com/abstract=228982

Jonathan W. Lewellen

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States
603-646-8650 (Phone)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

Jay A. Shanken (Contact Author)

Emory University - Goizueta Business School ( email )

1300 Clifton Road
Atlanta, GA 30322-2722
United States
404-727-4772 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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