The Journal of Finance

Portfolio Selection and Asset Pricing Models

Published: 03/31/2007   |   DOI: 10.1111/0022-1082.00204

Ľuboš Pástor

Finance theory can be used to form informative prior beliefs in financial decision making. This paper approaches portfolio selection in a Bayesian framework that incorporates a prior degree of belief in an asset pricing model. Sample evidence on home bias and value and size effects is evaluated from an asset‐allocation perspective. U.S. investors' belief in the domestic CAPM must be very strong to justify the home bias observed in their equity holdings. The same strong prior belief results in large and stable optimal positions in the Fama–French book‐to‐market portfolio in combination with the market since the 1940s.

Stock Valuation and Learning about Profitability

Published: 09/11/2003   |   DOI: 10.1111/1540-6261.00587

Ľuboš Pástor, Veronesi Pietro

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market‐to‐book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firm's lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Inequality Aversion, Populism, and the Backlash against Globalization

Published: 09/14/2021   |   DOI: 10.1111/jofi.13081

ĽUBOŠ PÁSTOR, PIETRO VERONESI

Motivated by the recent rise of populism in Western democracies, we develop a tractable equilibrium model in which a populist backlash emerges endogenously in a strong economy. In the model, voters dislike inequality, especially the high consumption of “elites.” Economic growth exacerbates inequality due to heterogeneity in preferences , which leads to heterogeneity in returns on capital. In response to rising inequality, voters optimally elect a populist promising to end globalization. Equality is a luxury good. Countries with more inequality, higher financial development, and trade deficits are more vulnerable to populism, both in the model and in the data.

Are Stocks Really Less Volatile in the Long Run?

Published: 03/27/2012   |   DOI: 10.1111/j.1540-6261.2012.01722.x

ĽUBOŠ PÁSTOR, ROBERT F. STAMBAUGH

According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long‐horizon variance but is more than offset by various uncertainties faced by the investor. The same uncertainties reduce desired stock allocations of long‐horizon investors contemplating target‐date funds.

Rational IPO Waves

Published: 08/12/2005   |   DOI: 10.1111/j.1540-6261.2005.00778.x

ĽUBOŠ PÁSTOR, PIETRO VERONESI

We argue that the number of firms going public changes over time in response to time variation in market conditions. We develop a model of optimal initial public offering (IPO) timing in which IPO waves are caused by declines in expected market return, increases in expected aggregate profitability, or increases in prior uncertainty about the average future profitability of IPOs. We test and find support for the model's empirical predictions. For example, we find that IPO waves tend to be preceded by high market returns and followed by low market returns.

Estimating the Intertemporal Risk–Return Tradeoff Using the Implied Cost of Capital

Published: 11/11/2008   |   DOI: 10.1111/j.1540-6261.2008.01415.x

ĽUBOŠ PÁSTOR, MEENAKSHI SINHA, BHASKARAN SWAMINATHAN

We argue that the implied cost of capital (ICC), computed using earnings forecasts, is useful in capturing time variation in expected stock returns. First, we show theoretically that ICC is perfectly correlated with the conditional expected stock return under plausible conditions. Second, our simulations show that ICC is helpful in detecting an intertemporal risk–return relation, even when earnings forecasts are poor. Finally, in empirical analysis, we construct the time series of ICC for the G–7 countries. We find a positive relation between the conditional mean and variance of stock returns, at both the country level and the world market level.

Costs of Equity Capital and Model Mispricing

Published: 05/06/2003   |   DOI: 10.1111/0022-1082.00099

Ľuboš Pástor, Robert F. Stambaugh

Costs of equity for individual firms are estimated in a Bayesian framework using several factor‐based pricing models. Substantial prior uncertainty about mispricing often produces an estimated cost of equity close to that obtained with mispricing precluded, even for a stock whose average return departs significantly from the pricing model's prediction. Uncertainty about which pricing model to use is less important, on average, than within‐model parameter uncertainty. In the absence of mispricing uncertainty, uncertainty about factor premiums is generally the largest source of overall uncertainty about a firm's cost of equity, although uncertainty about betas is nearly as important.

Predictive Systems: Living with Imperfect Predictors

Published: 07/16/2009   |   DOI: 10.1111/j.1540-6261.2009.01474.x

ĽUBOŠ PÁSTOR, ROBERT F. STAMBAUGH

We develop a framework for estimating expected returns—a predictive system—that allows predictors to be imperfectly correlated with the conditional expected return. When predictors are imperfect, the estimated expected return depends on past returns in a manner that hinges on the correlation between unexpected returns and innovations in expected returns. We find empirically that prior beliefs about this correlation, which is most likely negative, substantially affect estimates of expected returns as well as various inferences about predictability, including assessments of a predictor's usefulness. Compared to standard predictive regressions, predictive systems deliver different expected returns with higher estimated precision.

The Price of Political Uncertainty: Theory and Evidence from the Option Market

Published: 03/01/2016   |   DOI: 10.1111/jofi.12406

BRYAN KELLY, ĽUBOŠ PÁSTOR, PIETRO VERONESI

We empirically analyze the pricing of political uncertainty, guided by a theoretical model of government policy choice. To isolate political uncertainty, we exploit its variation around national elections and global summits. We find that political uncertainty is priced in the equity option market as predicted by theory. Options whose lives span political events tend to be more expensive. Such options provide valuable protection against the price, variance, and tail risks associated with political events. This protection is more valuable in a weaker economy and amid higher political uncertainty. The effects of political uncertainty spill over across countries.

Do Funds Make More When They Trade More?

Published: 03/19/2017   |   DOI: 10.1111/jofi.12509

ĽUBOŠ PÁSTOR, ROBERT F. STAMBAUGH, LUCIAN A. TAYLOR

We model fund turnover in the presence of time‐varying profit opportunities. Our model predicts a positive relation between an active fund's turnover and its subsequent benchmark‐adjusted return. We find such a relation for equity mutual funds. This time‐series relation between turnover and performance is stronger than the cross‐sectional relation, as the model predicts. Also as predicted, the turnover‐performance relation is stronger for funds trading less‐liquid stocks and funds likely to possess greater skill. Turnover is correlated across funds. The common component of turnover is positively correlated with proxies for stock mispricing. Turnover of similar funds helps predict a fund's performance.

Judging Fund Managers by the Company They Keep

Published: 05/03/2005   |   DOI: 10.1111/j.1540-6261.2005.00756.x

RANDOLPH B. COHEN, JOSHUA D. COVAL, ĽUBOŠ PÁSTOR

We develop a performance evaluation approach in which a fund manager's skill is judged by the extent to which the manager's investment decisions resemble the decisions of managers with distinguished performance records. The proposed performance measures use historical returns and holdings of many funds to evaluate the performance of a single fund. Simulations demonstrate that our measures are particularly useful in ranking managers. In an application that relies on such ranking, our measures reveal strong predictability in the returns of U.S. equity funds. Our measures provide information about future fund returns that is not contained in the standard measures.