Incremental Variables and the Investment Opportunity Set

47 Pages Posted: 15 Oct 2014 Last revised: 17 Apr 2015

See all articles by Eugene F. Fama

Eugene F. Fama

University of Chicago - Finance

Kenneth R. French

Dartmouth College - Tuck School of Business; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2015

Abstract

Variables with strong marginal explanatory power in cross-section asset pricing regressions typically show less power to produce increments to average portfolio returns, for two reasons. (i) Adding an explanatory variable can attenuate the slopes in a regression. (ii) Adding a variable with marginal explanatory power always attenuates the values of other explanatory variables in the extremes of the regression’s fitted values. Without a restriction on portfolio weights, the maximum Sharpe ratios in the GRS statistic provide little information about an incremental variable’s impact on the portfolio opportunity set.

Keywords: Incremental variables, Investment opportunity set, Portfolio returns, Variable attenuation

JEL Classification: G11, G12

Suggested Citation

Fama, Eugene F. and French, Kenneth R., Incremental Variables and the Investment Opportunity Set (April 1, 2015). Chicago Booth Research Paper No. 14-35, Fama-Miller Working Paper, Available at SSRN: https://ssrn.com/abstract=2509529 or http://dx.doi.org/10.2139/ssrn.2509529

Eugene F. Fama (Contact Author)

University of Chicago - Finance ( email )

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Kenneth R. French

Dartmouth College - Tuck School of Business ( email )

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National Bureau of Economic Research (NBER)

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