Portfolio Selection and Asset Pricing Models

TLDR

Finance theory can be used to form informative prior beliefs in financial decision making. The paper investigates portfolio selection using a Bayesian framework that incorporates a prior degree of belief in an asset pricing model. The authors evaluate evidence on home bias, value, and size effects from an asset‑allocation perspective within this Bayesian framework. Strong prior belief in the domestic CAPM is required to explain U.S.

Abstract

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.