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(Mis)Understanding Benign Overfitting in Equity Return Prediction

Highly overparameterized models often predict well despite interpolating training data in complex domains, challenging the classical bias--variance tradeoff. We investigate whether this ``benign overfitting'' phenomenon extends to equity return prediction.

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2026
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arxiv.org/abs/2608.23761ARXIV-DEFAULT
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Abstract

Highly overparameterized models often predict well despite interpolating training data in complex domains, challenging the classical bias--variance tradeoff. We investigate whether this ``benign overfitting'' phenomenon extends to equity return prediction. Consistent with recent statistical theory, we document two key phenomena: first, a double descent pattern in the ridgeless model's prediction risk; and second, that while the optimal ridge model consistently outperforms its ridgeless counterpart, this performance gap becomes negligible at large parameter-to-observation ratios. Ultimately, however, both models fail to outperform a simple historical average. This empirical evidence aligns with our asymptotic results under the null hypothesis of zero slope coefficients, suggesting that standard equity predictors lack true forecasting power---even within highly flexible, nonlinear machine learning architectures. These findings reconcile modern and classical machine learning in asset pricing: in the absence of a true signal, they asymptotically collapse to the historical average benchmark.