Neoclassical Factors

We propose a new multifactor model that consists of the market factor and factor mimicking portfolios based on investment and productivity motivated from neoclassical reasoning. The neoclassical three-factor model goes a long way in explaining the average returns across testing portfolios formed on momentum, financial distress, investment, profitability, net stock issues, and valuation ratios. In particular, winners have higher loadings than losers on both the low-minus-high investment factor and the high-minus-low productivity factor. We suggest that the neoclassical model is a good start to understanding the cross-sectional variations of average stock returns. Olin School of Business, Washington University in St. Louis, Campus Box 1133, One Brookings Drive, St. Louis MO 63130-4899. Finance Department, Stephen M. Ross School of Business, University of Michigan, 701 Tappan, ER 7605 Bus Ad, Ann Arbor MI 48109-1234; and NBER. Tel: (734) 615-4854, fax: (734) 936-0282, and e-mail: [email protected]. For helpful discussions, we thank Sreedhar Bharath, Ken French, Gerald Garvey (BGI discussant), Tyler Shumway, Richard Sloan, Scott Richardson, Motohiro Yogo (UBC discussant), and seminar participants at Barclays Global Investors, Hong Kong University of Science and Technology, UBC PH&N Summer Finance Conference in 2007, and University of Michigan. Cynthia Jin provided valuable assistance in early stages of this project.