We construct a Broad Market Factor (BMF), which is a proxy for the value-weighted equity return on all firms in the US economy (public and private). The BMF differs from the standard Value-weighted Market Factor (VMF), which reflects the value-weighted equity return on public firms. We define the difference between the VMF and the BMF to be the Idiosyncratic Financial Factor (IFF). The IFF carries no risk premium and is uncorrelated with all macroeconomic proxies for investor marginal utility we consider. CAPM betas and, consequently, discount rates are underestimated when measured with respect to the VMF compared to the BMF for most portfolios. Size factors become redundant and the size anomaly is resolved when the VMF is replaced by the BMF in standard factor models. The intertemporal risk-return relation is substantially stronger when one replaces the VMF with the BMF. The unifying explanation for these results is that the IFF adds unpriced risk to the VMF, distorting both cross-sectional and time-series estimates of exposure to priced market risk.
