Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Alternative interpretations for return predictability

• Observed return predictability over time can reflect time-varying risk premia, market inefficiency, or a mirage. Parallel interpretations (rational, irrational, noise) exist to explain large average return differences across assets.

• Each interpretation has different investment implications. However, it is often impossible to empirically distinguish these explanations from one another, and they may all matter.

• “Mirage” is my catch-all term for explanations that do not imply investment opportunities for the future: data mining and selection biases, peso problems and learning, market frictions and structural changes.

7.1 RISK PREMIA OR MARKET INEFFICIENCY

The two main competing explanations for return predictability are time-varying risk premia and market inefficiency. (As a cross-sectional parallel to time series predictability, abnormally high average returns for certain assets or investment strategies also have both rational and irrational explanations.) The two alternatives are often empirically indistinguishable and a spirited debate about them has persisted for over two decades. In reality both explanations likely have contributed to observed regularities. These two explanations have been discussed in the previous chapters, so I keep things brief here.

Time-varying risk premia may reflect either assets’ changing riskiness or investors’ changing risk aversion over time—or both. Either way, time-varying opportunities ...