Hostname: page-component-76fb5796d-wq484 Total loading time: 0 Render date: 2024-04-26T13:44:30.965Z Has data issue: false hasContentIssue false
  • English
  • Français

The Poor Predictive Performance of Asset Pricing Models

Published online by Cambridge University Press:  06 April 2009

Timothy Simin
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper examines time-series forecast errors of expected returns from conditional and unconditional asset pricing models for portfolio and individual firm equity returns. A new result that increases predictive precision concerning model specification and forecasting is introduced. Conditional versions of the models generally produce higher mean squared errors than unconditional versions for step ahead prediction. This holds for individual firm data when the instruments are firm specific. Mean square forecast error decompositions indicate that the asset pricing models produce relatively unbiased predictions, but the variance is severe enough to ruin the step ahead predictive ability beyond that of a constant benchmark.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 43 , Issue 2 , June 2008 , pp. 355 - 380
Copyright
Copyright © School of Business Administration, University of Washington 2008

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Avramov, D., and Chordia, T.. “Asset Pricing Models and Financial Market Anomalies.” Review of Financial Studies, 19 (2006), 1001–1040.CrossRefGoogle Scholar
Basu, S. “The Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: Test of the Efficient Markets Hypothesis.” Journal of Finance, 32 (1977), 663–682.Google Scholar
Bossaerts, P., and Hillion, P.. “Implementing Statistical Criteria to Select Return Forecasting Models: What Do We Learn?” Review of Financial Studies, 12 (1999), 405–428.CrossRefGoogle Scholar
Braun, P. A.; Nelson, D. B.; and Sunier, A. M.. “Good News, Bad News, Volatility and Betas.” Journal of Finance, 50 (1995), 1575–1603.CrossRefGoogle Scholar
Brealey, R. A., and Myers, S. C.. Principles of Corporate Finance, 6th ed.New York: McGraw Hill (2000).Google Scholar
Brennan, M. J.; Chordia, T.; and Subrahmanyam, A.. “Alternative Factor Specifications, Security Characteristics, and the Cross-Section of Expected Stock Returns.” Journal of Financial Economics, 49 (1998), 345–373.CrossRefGoogle Scholar
Bruner, R. F.; Eades, K. M.; Harris, R. S.; and Higgins, R. C.. “Best Practices in Estimating the Cost of Capital: Survey and Synthesis.” Financial Management, 27 (1998), 13–28.Google Scholar
Chen, N. F.; Roll, R.; and Ross, S. A.. “Economic Forces and the Stock Market.” Journal of Business, 59 (1986), 383–403.CrossRefGoogle Scholar
Cochrane, J. H. “A Rehabilitation of the Stochastic Discount Factor Methodology.” Working Paper #8533, NBER (2001).CrossRefGoogle Scholar
Connor, G., and Korajczyk, R. A.. “Estimating Pervasive Economic Factors with Missing Observations.” Working Paper 34, Northwestern University (1988).Google Scholar
Connor, G., and Korajczyk, R. A.. “A Test for the Number of Factors in an Approximate Factor Model.” Journal of Finance, 48 (1993), 1263–1291.CrossRefGoogle Scholar
Cooper, M., and Gulen, H.. “Is Time-Series Based Predictability Evident in Real Time?” Journal of Business, 79 (2006), 1263–1292.CrossRefGoogle Scholar
Daniel, K., and Titman, S.. “Evidence on the Characteristics of Cross-Sectional Variation in Stock Returns.” Journal of Finance, 52 (1997), 1–33.CrossRefGoogle Scholar
Dhillon, U., and Johnson, H.. “Changes in the Standard and Poor's 500 List.” Journal of Business, 64 (1991), 75–85.CrossRefGoogle Scholar
Ellis, D. M. “A Test of the Conditional CAPM with Simultaneous Estimation of the First and Second Conditional Moments.” Financial Review, 31 (1996), 475–498.CrossRefGoogle Scholar
Erwin, G. R., and Miller, J. M.. “The Liquidity Effects Associated with Addition of a Stock to the S&P 500 Index: Evidence from Bid/Ask Spreads.” Financial Review, 33 (1998), 131–146.CrossRefGoogle Scholar
Evans, M. D. “Expected Returns, Time-Varying Risk, and Risk Premia.” Journal of Finance, 49 (1994), 655–679.Google Scholar
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Multifactor Explanations of Asset Pricing Anomalies.” Journal of Finance, 51 (1996), 55–84.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Industry Costs of Equity.” Journal of Financial Economics, 43 (1997), 153–193.CrossRefGoogle Scholar
Fama, E., and MacBeth, J.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.CrossRefGoogle Scholar
Farnsworth, H.; Ferson, W. E.; Jackson, D.; and Todd, S.. “Performance Evaluation with Stochastic Discount Factors.” Journal of Business, 75 (2002), 473–503.CrossRefGoogle Scholar
Ferson, W. E., and Harvey, C. R.. “The Variation of Economic Risk Premiums.” Journal of Political Economy, 99 (1991), 385–415.CrossRefGoogle Scholar
Ferson, W. E., and Harvey, C. R.. “The Risk and Predictability of International Equity Returns.” Review of Financial Studies, 6 (1993), 527–566.CrossRefGoogle Scholar
Ferson, W. E., and Harvey, C. R.. “Predictability and Time-Varying Risk in World Equity Markets.” Research in Finance, 13 (1995), 25–85.Google Scholar
Ferson, W. E., and Harvey, C. R.. “Fundamental Determinants of National Equity Market Returns: A Perspective on Conditional Asset Pricing.” Journal of Banking and Finance, 21 (1997), 1625–1665.CrossRefGoogle Scholar
Ferson, W. E., and Harvey, C. R.. “Conditional Variables and the Cross-Section of Stock Returns.” Journal of Finance, 54 (1999), 1325–1360.CrossRefGoogle Scholar
Ferson, W. E., and Korajczyk, R. A.. “Do Arbitrage Pricing Models Explain the Predictability of Stock Returns?” Journal of Business, 68 (1995), 309–349.CrossRefGoogle Scholar
Ferson, W. E., and Locke, D. H.. “Estimating the Cost of Capital through Time: An Analysis of the Sources of Error.” Management Science, 44 (1998), 485–500.CrossRefGoogle Scholar
Ferson, W., and Qian, M.. “Conditional Performance Evaluation Revisited.” Monograph, The Research Foundation of the CFA Institute (2004).Google Scholar
Ferson, W. E.; Sarkissian, S.; and Simin, T. T.. “Spurious Regressions in Financial Economics?” Journal of Finance, 58 (2003), 1393–1413.CrossRefGoogle Scholar
Foster, F. D.; Smith, T.; and Whaley, R. E.. “Assessing Goodness-of-Fit of Asset Pricing Models: The Distribution of the Maximal R2.” Journal of Finance, 52 (1997), 591–607.Google Scholar
Ghysels, E. “On Stable Factor Structures in the Pricing of Risk: Do Time-Varying Betas Help or Hurt?” Journal of Finance, 53 (1998), 549–573.CrossRefGoogle Scholar
Giacomini, R., and White, H.. “Tests of Conditional Predictive Ability.” Working Paper #572, Boston College (2005).Google Scholar
Gibbons, M., and Ferson, W. E.. “Testing Asset Pricing Models with Changing Expectations and an Unobservable Market Portfolio.” Journal of Financial Economics, 14 (1985), 217–236.CrossRefGoogle Scholar
Gitman, L. J., and Mercurio, V. A.. “Cost of Capital Techniques Used by Major U.W. Firms: Survey and Analysis of Fortune's 1000.” Financial Management, Winter (1982), 21–29.CrossRefGoogle Scholar
Goyal, A., and Welch, I.. “Predicting the Equity Premium.” Working Paper, UCLA (1999).Google Scholar
Goyal, A., and Welch, I.. “The Myth of Predictability: Does the Dividend Yield Forecast the Equity Premium?” Management Science, 49 (2003), 639–654.CrossRefGoogle Scholar
Goyal, A., and Welch, I.. “A Comprehensive Look at the Empirical Performance of Equity Premium Prediction.” Review of Financial Studies (forthcoming).Google Scholar
Graham, J. R., and Harvey, C. R.. “The Theory and Practice of Corporate Finance: Evidence from the Field.” Journal of Financial Economics, 60 (2001), 187–243.CrossRefGoogle Scholar
Grinold, R. C., and Kahn, R. N.. Active Portfolio Management: Quantitative Theory and Applications. New York, NY: McGraw-Hill (1995).Google Scholar
Hanna, D., and Ready, M.. “Profitable Predictability in the Cross-Section of Stock Returns.” Journal of Financial Economics, 78 (2005), 463–505.CrossRefGoogle Scholar
Hansen, L. P. “Large Sample Properties of Generalized Method of Moments Estimators.” Econometrica, 50 (1982), 1029–1054.CrossRefGoogle Scholar
Harvey, C. R. “Time-Varying Conditional Covariances in Tests of Asset Pricing Models.” Journal of Financial Economics, 24 (1989), 289–317.CrossRefGoogle Scholar
Harvey, C. R., and Siddique, A.. “Conditional Skewness in Asset Pricing Tests.” Journal of Finance, 55 (2000), 1263–1295.CrossRefGoogle Scholar
Haugen, R. A., and Baker, N. L.. “Commonality in the Determinants of Expected Stock Returns.” Journal of Financial Economics, 41 (1996), 401–439.CrossRefGoogle Scholar
He, J.; Kan, R.; Ng, L.; and Zhang, C.. “Tests of the Relations among Market-Wide Factors, Firm Specific Variables, and Stock Returns Using a Conditional Asset Pricing Model.” Journal of Finance, 51 (1996), 1891–1908.Google Scholar
Inoue, A., and Kilian, L.. “In-Sample or Out-of-Sample Tests of Predictability: Which One Should We Use?” Econometric Reviews, 23 (2004), 371–402.CrossRefGoogle Scholar
Jagannathan, R., and Wang, Z.. “The Conditional CAPM and the Cross-Section of Expected Returns.” Journal of Finance, 51 (1996), 3–53.Google Scholar
Jagannathan, R., and Wang, Z.. “Empirical Evaluation of Asset Pricing Models: A Comparison of the SDF and Beta Methods.” Journal of Finance, 57 (2002), 2337–2367.CrossRefGoogle Scholar
James, W., and Stein, C.. “Estimation with Quadratic Loss.” In Proceedings of the Fourth Berkeley Symposium on Mathematical Statistics and Probability, Vol. 1, Neyman, J., ed. University of California Press (1961).Google Scholar
Jegadeesh, N., and Titman, S.. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 48 (1993), 65–91.CrossRefGoogle Scholar
Jegadeesh, N., and Titman, S.. “‘Profitability of Momentum Strategies: An Evaluation of Alternative Explanations”. Journal of Finance, 56 (2001), 699–720.CrossRefGoogle Scholar
Jorion, P. “Bayes-Stein Estimation for Portfolio Analysis.” Journal of Financial and Quantitative Analysis, 21 (1986), 279–292.CrossRefGoogle Scholar
Kan, R., and Zhang, C.. “Two-Pass Tests of Asset Pricing Models with Useless Factors.” Journal of Finance, 54 (1999a), 203–235.CrossRefGoogle Scholar
Kan, R., and Zhang, C.. “GMM Tests of Stochastic Discount Factor Models with Useless Factors.” Journal of Financial Economics, 54 (1999b), 103–127.CrossRefGoogle Scholar
Kan, R., and Zhou, G.. “A Critique of the Stochastic Discount Factor Methodology.” Journal of Finance, 54 (1999), 1221–1248.CrossRefGoogle Scholar
Kan, R., and Zhou, G.. “Empirical Asset Pricing: The Beta Method versus the Stochastic Discount Factor Method.” Working Paper, University of Toronto (2001).Google Scholar
Kim, D. “The Errors in the Variables Problem in the Cross-Section of Expected Stock Returns.” Journal of Finance, 52 (1995), 1605–1634.Google Scholar
Kirby, C. “Measuring the Predictable Variation in Stock and Bond Returns.” Review of Financial Studies, 10 (1997), 579–630.CrossRefGoogle Scholar
Leitch, G., and Tanner, J. E.. “Economic Forecast Evaluation: Profits versus the Conventional Error Measures.” American Economic Review, 81 (1991), 580–590.Google Scholar
Lettau, M., and Ludvigson, S.. “Resurrecting the (C)CAPM: A Cross-Sectional Test When Risk Premia Are Time-Varying.” Journal of Political Economy, 109 (2001), 1238–1287.CrossRefGoogle Scholar
Lintner, J. “The Valuation of Risky Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics, 47 (1965), 13–37.CrossRefGoogle Scholar
Lo, A., and MacKinlay, A. C.. “Data-Snooping Biases in Tests of Financial Asset Pricing Models.” Review of Financial Studies, 3 (1990a), 431–468.CrossRefGoogle Scholar
Lo, A., and MacKinlay, A. C.. “When Are Contrarian Profits Due to Stock Market Overreaction?” Review of Financial Studies, 3 (1990b), 175–205.CrossRefGoogle Scholar
Maheu, J. M., and McCurdy, T. H.. “How Useful Are Historical Data for Forecasting the Long-Run Equity Premium?” Working Paper, University of Toronto (2006).Google Scholar
Martin, R. D., and Simin, T. T.. “Outlier Resistant Estimates of Beta.” Financial Analysts Journal, 59 (2003), 56–69.CrossRefGoogle Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroscedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.CrossRefGoogle Scholar
Pástor, L., and Stambaugh, R. F.. “Cost of Equity Capital and Model Mispricing.” The Journal of Finance, 54 (1999), 67–121.CrossRefGoogle Scholar
Rosenberg, B., and Marathe, V.. “Tests of Capital Asset Pricing Hypotheses.” Research in Finance, 1 (1979), 115–223.Google Scholar
Rosenberg, B., and McKibben, W.. “The Prediction of Systematic and Specific Risk in Common Stocks.” Journal of Financial and Quantitative Analysis, 8 (1973), 317–333.CrossRefGoogle Scholar
Ross, S. A. “The Arbitrage Theory of Capital Asset Pricing.” Journal of Economic Theory, 13 (1976), 341–360.CrossRefGoogle Scholar
Sharpe, W. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance, 19 (1964), 425–442.Google Scholar
Wheatley, S. “Evaluating Asset Pricing Models.” Working Paper, Australian Graduate School of Management (1998).Google Scholar