Stock Return Predictability and Asset Pricing Models
Posted: 4 Aug 2003
This paper considers asset allocation in a framework that incorporates a prior degree of belief into the restrictions on stock return predictability implied by asset pricing models. Investors' beliefs in the pricing restrictions are updated by the data, and asset allocation is made on the basis of the updated beliefs. Asset allocation departs considerably from the model implications even when the prior reflects the recognition of just a modest amount of model misspecification. In out-of-sample experiments, optimal portfolios perform well when the pricing restrictions are perceived to be useful but imperfect, and conditional asset pricing models substantially outperform their unconditional counterparts.
JEL Classification: G11, G12, C11
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