Article2010

A Better Three-Factor Model That Explains More Anomalies

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Financial Markets and Investment Strategies Financial Analysis and Corporate Governance Financial Reporting and Valuation Research

Abstract

The market factor, an investment factor, and a return-on-assets factor summarize the cross-sectional variation of expected stock returns. The new three-factor model substantially outperforms traditional asset pricing models in explaining anomalies associated with short-term prior returns, financial distress, net stock issues, asset growth, earnings surprises, and valuation ratios. The model’s performance, combined with its economic intuition based on q-theory, suggests that it can be used to obtain expected return estimates in practice.

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1993Common risk factors in the returns on stocks and bonds 1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1997On Persistence in Mutual Fund Performance 1992The Cross-Section of Expected Stock Returns 1968FINANCIAL RATIOS, DISCRIMINANT ANALYSIS AND THE PREDICTION OF CORPORATE BANKRUPTCY 1993Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency 1985Does the Stock Market Overreact?1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]

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