A Dynamic Model of Characteristic-Based Return Predictability

50 Pages Posted: 30 Apr 2019 Last revised: 7 Jun 2021

See all articles by Aydogan Alti

Aydogan Alti

University of Texas at Austin - Department of Finance

Sheridan Titman

University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)

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Date Written: April 2019

Abstract

We present a dynamic model that links characteristic-based return predictability to systematic factors that determine the evolution of firm fundamentals. In the model, an economy-wide disruption process reallocates profits from existing businesses to new projects and thus generates a source of systematic risk for portfolios of firms sorted on value, profitability, and asset growth. If investors are overconfident about their ability to evaluate the disruption climate, these characteristic-sorted portfolios exhibit persistent mispricing. The model generates predictions about the conditional predictability of characteristic-sorted portfolio returns and illustrates how return persistence increases the likelihood of observing characteristic-based anomalies.

Suggested Citation

Alti, Aydogan and Titman, Sheridan, A Dynamic Model of Characteristic-Based Return Predictability (April 2019). NBER Working Paper No. w25777, Available at SSRN: https://ssrn.com/abstract=3379457

Aydogan Alti (Contact Author)

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States

Sheridan Titman

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-232-2787 (Phone)
512-471-5073 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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