Asset pricing model uncertainty: a tradeoff between bias and variance

This paper draws a parallel between model combination and the mean–
variance tradeoff in Modern Portfolio Theory (Markowitz 1952) and proposes
a bias–variance tradeoff framework. Building on the bias–variance tradeoff
framework, the paper proposes a Model Portfolio Approach (MPA) and a
Global Minimum Variance (GMV) weighting scheme to mitigate asset pricing
model uncertainty. Using a well-conditioned pricing covariance estimator,
the proposed approach improves out-of-sample pricing performance over six
widely used asset pricing models, a model selection method and two most
popular benchmarks in existing model combination studies, that is, the
simple arithmetic average (“1/N”) and Ordinary Least Square (OLS) weighting
methods.