Can An Investor Profit from Return Predictability in Real Time?

Abstract:     
Despite the extensive empirical evidence on return predictability, the question whether investors can profit from return predictability in real time remains unsettled. One problem is that the predictive model is likely misspecified, which has received little attention. By taking a more careful approach that guards against model mis-specification, we study the economic significance of return predictability by evaluating extensively the out-of-sample portfolio performance of various predictive models and variations of predictive variables. We find that investors can benefit from predicting the sign, but not the magnitude, of the market expected returns only in periods when the market performs poorly. We also find that there is no significant performance difference among the predictive models, although the best statistical model often performs the worst and a GARCH feature seems important.

Number of Pages in PDF File: 36

Keywords: Return predictability, Economic value, Portfolio performance, nonlinearity

working papers series