The Investment Manifesto

Abstract

A deep-ingrained doctrine in asset pricing says that if an empirical characteristic-return relation is consistent with investor “rationality,” the relation must be “explained” by a risk (factor) model. The investment approach questions the doctrine. Factors formed on characteristics are not necessarily risk factors; characteristics-based factor models are linear approximations of firm-level investment returns. The evidence that characteristics dominate covariances in horse races does not necessarily mean mispricing; measurement errors in covariances are likely to blame. Most important, risks do not “determine” expected returns; the investment approach is no more and no less “causal” than the consumption approach in “explaining” anomalies.

Keywords: the risk doctrine, investment-based asset pricing, measurement errors in covariances, characteristics, asset pricing anomalies

JEL Classification: D21, D92, E22, E44, G12, G14, G31, G32, G35