What is an outcome of model mis-specification?

Model mis-specification refers to the situation where a model is incorrectly specified, which can lead to inaccurate or misleading results. One significant outcome of model mis-specification is the omission of systematic return factors. When relevant variables that affect returns are not included in the model, the model is unable to capture the complete picture of the relationships at play. As a result, important influences on a portfolio's performance may be ignored, leading to incomplete analyses and erroneous conclusions about risk and return dynamics.

The absence of systematic return factors can cause the model to generate biased estimates of expected returns and risks, ultimately impairing decision-making. This can significantly affect an investor's ability to assess the true risk exposure of an investment or portfolio.

In contrast, identifying return factors correctly or assuming all variables behave linearly are outcomes that would be more aligned with a correctly specified model. Non-linear risk-return relationships might arise in certain contexts; however, they are not inherently a consequence of model mis-specification but rather a characteristic of certain financial instruments or markets. Therefore, the recognition of omitted systematic return factors as a direct outcome of model mis-specification effectively highlights the critical importance of including all relevant variables in financial modeling for accurate analysis.