The Performance of Characteristic-Sorted Portfolios: Evaluating the Past and Predicting the Future

The expected returns of most portfolios are likely to fluctuate over time. We present a statistical model that allows for such fluctuations and apply the model to analyze the returns of characteristic-sorted portfolios, such as value minus growth. We find that accounting for plausible magnitudes of persistent variation in returns doubles the standard errors of these portfolios’ expected return estimates. We also analyze characteristic-sorted portfolios from the perspective of Bayesian investors and show that investors’ posterior beliefs about expected returns are highly dependent on their priors about persistence.