Chapter 16 established that a security s risk premium is the sum of a fundamental-based premium and a sentiment-based premium. In other words, the risk premium is not determined by fundamental risk alone. The traditional explanation for risk premiums is through beta. In this respect, a key lesson from Chapter 17 is that investor errors do not prevent risk premiums being determined by beta. Rather, the concepts of beta and mean-variance efficiency are as applicable in inefficient markets as in efficient markets. At the same time, nonzero sentiment alters the character of the mean-variance portfolio.

Figure 17.1 contrasts the return profile of a mean-variance efficient portfolio when prices are inefficient with the return profile of a mean-variance efficient portfolio when prices are efficient. Notice that when prices are efficient, mean-variance returns approximately correspond to a weighted average of the market portfolio and the risk-free security. However, when prices are inefficient, mean-variance returns oscillate. This is important, because when prices are inefficient, the risk premium associated with any security depends on how the security s return distribution covaries with the oscillating mean-variance return profile, not the market portfolio. Recall that the oscillations correspond to market mispricing. Therefore, the return premium to any security depends on the degree to which the return profile of that security reflects the same mispricing pattern as the mean-variance profile.

The concepts just stated serve as the backdrop for discussing the literature on the cross-section of expected returns, or the characteristics literature. This literature has been the focal...