The reason for the failure of asset pricing models can be divided into several: Transaction costs, investors’ irrationality, or missing risk factors. The objective of this paper is to find which of these candidates is the most important reason for the failure. To accomplish this object, we investigate the relation between explanatory power of various asset pricing models and variables related to the failure of asset pricing models. First, we find that both transaction costs and investors’ irra-tionality have statistically significant relation with the difference of realized return from ex-pected return reported by the CAPM even after size and book-to-market are included in the Fama-Macbeth regression. Second, we implement the same testing procedure of the CAPM to the Fama and French three factor model and the Carhart four factor model. The results of re-gressions are all similar to the CAPM’s. If a missing risk factor is the main reason for the failure of the CAPM, and the three factor model at least improves the CAPM, we should ob-serve a different pattern of regression coefficients. However, all Wald statistics cannot reject the null hypothesis that the regression coefficients of asset pricing models are the same. Therefore, we argue that poor performance of the asset pricing models is resulted from both trans-action costs and investors’ irrationality, rather than missing factors.
Keywords:Asset pricing Model, Transaction cost, Investors’ irrationality, Missing risk factor, Fama and Macbeth (1973) regression.