Predictive Systems: Living with Imperfect Predictors
University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
Robert F. Stambaugh
University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)
July 21, 2008
CRSP Working Paper No. 617
EFA 2007 Ljubljana Meetings Paper
We develop a framework for estimating expected returns - a predictive system - that allows predictors to be imperfectly correlated with the conditional expected return. When predictors are imperfect, the estimated expected return depends on past returns in a manner that hinges on the correlation between unexpected returns and innovations in expected returns. We find empirically that prior beliefs about this correlation, which is most likely negative, substantially affect estimates of expected returns as well as various inferences about predictability, including assessments of a predictor's usefulness. Compared to standard predictive regressions, predictive systems deliver different and more precise estimates of expected returns.
Number of Pages in PDF File: 51
Keywords: predictability, expected stock return, state space model, predictive system, predictive regression, imperfect predictors, Bayesian
JEL Classification: G1
Date posted: February 19, 2007 ; Last revised: December 13, 2011
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