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Asset pricing model uncertainty and portfolio choice

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  • Carrasco, Ignacio
  • Hansen, Erwin

Abstract

We study how asset pricing uncertainty affects the performance of a Bayesian mean-variance investor's portfolio allocation decisions. The investor allocates their wealth between a set of benchmark portfolios associated with a particular asset pricing model and a set of additional test assets. He centers their priors on model mispricing (alpha) around zero, but the true extent of mispricing is uncertain. When using recently introduced factor asset pricing models (Fama and French, 2015; and Hou et al., 2015), we find that allowing for mispricing uncertainty increases the point estimates of portfolio performance in most cases. However, their statistical significance is weaker.

Suggested Citation

  • Carrasco, Ignacio & Hansen, Erwin, 2022. "Asset pricing model uncertainty and portfolio choice," Finance Research Letters, Elsevier, vol. 45(C).
    • Handle: RePEc:eee:finlet:v:45:y:2022:i:c:s1544612321002257
    DOI: 10.1016/j.frl.2021.102144
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    References listed on IDEAS

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    1. Francisco Barillas & Jay Shanken, 2018. "Comparing Asset Pricing Models," Journal of Finance, American Finance Association, vol. 73(2), pages 715-754, April.
    2. Kewei Hou & Chen Xue & Lu Zhang, 2015. "Editor's Choice Digesting Anomalies: An Investment Approach," The Review of Financial Studies, Society for Financial Studies, vol. 28(3), pages 650-705.
    3. Fama, Eugene F. & French, Kenneth R., 2015. "A five-factor asset pricing model," Journal of Financial Economics, Elsevier, vol. 116(1), pages 1-22.
    4. Kewei Hou & Chen Xue & Lu Zhang, 2020. "Replicating Anomalies," The Review of Financial Studies, Society for Financial Studies, vol. 33(5), pages 2019-2133.
    5. Evan W. Anderson & Ai-Ru (Meg) Cheng, 2016. "Robust Bayesian Portfolio Choices," The Review of Financial Studies, Society for Financial Studies, vol. 29(5), pages 1330-1375.
    6. Pastor, Lubos & Stambaugh, Robert F., 2000. "Comparing asset pricing models: an investment perspective," Journal of Financial Economics, Elsevier, vol. 56(3), pages 335-381, June.
    7. Borup, Daniel, 2019. "Asset pricing model uncertainty," Journal of Empirical Finance, Elsevier, vol. 54(C), pages 166-189.
    8. Carhart, Mark M, 1997. "On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    9. Doron Avramov, 2004. "Stock Return Predictability and Asset Pricing Models," The Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 699-738.
    10. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    11. Eugene F. Fama & Kenneth R. French, 2016. "Dissecting Anomalies with a Five-Factor Model," The Review of Financial Studies, Society for Financial Studies, vol. 29(1), pages 69-103.
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    Cited by:

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    2. Hanauer, Matthias X. & Jansen, Maarten & Swinkels, Laurens & Zhou, Weili, 2024. "Factor models for Chinese A-shares," International Review of Financial Analysis, Elsevier, vol. 91(C).

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    More about this item

    Keywords

    Model uncertainty; Factor models; Bayesian investor; Portfolio performance;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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