A skeptical appraisal of asset pricing tests

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- B/ M portfolios, something many models seem to do remarkably well. In this paper, we review and critique the empirical methods used in the litera...

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Bibliographic Details
Published in:Journal of financial economics 2010-05, Vol.96 (2), p.175-194
Main Authors: Lewellen, Jonathan, Nagel, Stefan, Shanken, Jay
Format: Article
Language:English
Subjects:
Asset pricing
Asset pricing Cross-sectional tests Power
Cross-sectional tests
Financial engineering
Model testing
Power
Rates of return
Research methods
Review articles
Securities prices
Studies
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Summary: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- B/ M 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 R 2s and small pricing errors) can provide quite weak support for a model. We offer a number of suggestions for improving empirical tests and evidence that several proposed models do not work as well as originally advertised.
ISSN:0304-405X
1879-2774
DOI:10.1016/j.jfineco.2009.09.001