Adding a third factor provides a new mean-variance frontier, which appears in Figure 2 as a three-dimensional cone. Illustration B shows the mean frontier that is formed with the inclusion of a risk-free investment, like a government bond or a money market fund. In this case, the principal is the same as the two-factor model, except that portfolios that find their way into the efficient frontier can now be achieved with combinations of three types of funds: equities, bonds or money market funds, and a portfolio that is adjusted for the investor's chosen third factor.

Federal Reserve Bank of Chicago

Look at apparent free lunches with healthy skeptism

Never forget that for every investor who is buying a stock or asset class for its risk premium, there is another investor who is avoiding it because he feels that the risk is too high. This is an issue that is really on the front edge of the index investing debate. Current data tends to indicate that some asset classes, such as small cap. and value stocks carry a risk premium, meaning investors can expect higher returns from these asset classes. Some economists (such as Fama and French) believe that the premiums of certain asset classes are caused by higher risk. Others believe that this imbalance in pricing is caused by the irrational behavior of investors, who flock to equities that are in favor, and shy away from those that aren't. Cochrane sees economists as being about evenly divided between the two camps.

Understanding the reason for the market's behavior is critical to making the best investment decisions. If the risk is real, then you can invest in these equities - but with the understanding that you are gaining higher returns at the expense of additional risk. If the higher returns are indicative of irrational investor behavior, you would be a fool not to invest in the underbelly of a market inefficiency that is certain to revert back to the mean. However, if the irrational behavior is ingrained into the human psyche like, say flying in airplanes, it is for all intents and purposes the same as real risk. Cochrane advances another argument: that the risks are real, but narrowly held - thus a few investors are capturing a risk premium at a cheap price.
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