Investments, tenth edition

  Risk Premium Forecasts   

Panel 4 of  Spreadsheet 8.1  contains estimates of alpha and 

the risk premium for each stock. These alphas would be the most important production of 

the investment company in a real-life procedure. Statistics plays a small role here; in this 

arena, macro/security analysis is king. In this example, we simply use illustrative values to 

demonstrate the portfolio construction process and possible results. You may wonder why we 

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  C H A P T E R  

8

 Index 

Models

277

have chosen such small, forecast alpha values. The reason is that even when security analysis 

uncovers a large apparent mispricing, that is, large alpha values, these forecasts must be 

 substantially trimmed to account for the fact that such forecasts are subject to large estima-

tion error. We discuss the important procedure of adjusting actual forecasts in Chapter 27.