A Skeptical Appraisal of Asset-Pricing Tests
44 Pages Posted: 20 Jul 2006 Last revised: 11 Apr 2021
Date Written: July 2006
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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