Abstract

Previous work shows that average returns on common stocks are related to firm characteristics like size, earnings/price, cash flow/price, book-to-market equity, past sales growth, long-term past return, and short-term past return. Because these patterns in average returns apparently are not explained by the CAPM, they are called anomalies. We find that, except for the continuation of short-term returns, the anomalies largely disappear in a three-factor model. Our results are consistent with rational ICAPM or APT asset pricing, but we also consider irrational pricing and data problems as possible explanations.

Scientific Portfolio AI- Generated Summary

In their paper “Multifactor Explanations of Asset Pricing Anomalies,” Eugene F. Fama and Kenneth R. French explore the patterns in average stock returns and how they relate to firm characteristics. They also investigate the anomalies that cannot be explained by the Capital Asset Pricing Model (CAPM) and propose possible explanations for them.

The authors begin by examining the relationship between average stock returns and firm characteristics such as size, book-to-market equity, and momentum. They find that these characteristics are related to average stock returns and that they can be used to construct portfolios that outperform the market. They also find that the relationship between these characteristics and average stock returns is robust across time periods and countries.

Next, the authors investigate the anomalies that cannot be explained by the CAPM. They find that the CAPM is unable to explain the size and book-to-market effects, which are the most robust anomalies in the data. They propose a three-factor model that includes market risk, size, and book-to-market equity as factors that explain the cross-section of average stock returns. They find that this model is able to explain the size and book-to-market effects as well as other anomalies such as the momentum effect.

The authors also investigate the possible explanations for the anomalies that cannot be explained by the CAPM or the three-factor model. They propose that these anomalies may be due to mispricing caused by investor sentiment, liquidity risk, or other factors that are not captured by the models. They also propose that these anomalies may be due to risk factors that are not yet identified.

Overall, the authors conclude that the patterns in average stock returns are related to firm characteristics and that these characteristics can be used to construct portfolios that outperform the market. They also conclude that the anomalies that cannot be explained by the CAPM or the three-factor model may be due to mispricing or risk factors that are not yet identified. The paper provides a comprehensive analysis of the patterns in average stock returns and the factors that explain them, and it has had a significant impact on the field of finance.