Bayesian Inference and Portfolio Efficiency
Shmuel Kandel, Robert McCulloch, Robert F. Stambaugh
NBER Technical Working Paper No. 134
A Bayesian approach is used to investigate a sample's information about a portfolio's degree of inefficiency. With standard diffuse priors, posterior distributions for measures of portfolio inefficiency can concentrate well away from values consistent with efficiency, even when the portfolio is exactly efficient in the sample. The data indicate that the NYSE-AMEX market portfolio is rather inefficient in the presence of a riskless asset, although this conclusion is justified only after an analysis using informative priors. Including a riskless asset significantly reduces any sample's ability to produce posterior distributions supporting small degrees of inefficiency.
Published: in Review of Financial Studies August 1995, pp.1-53.