A Simple Explanation of the Forecast Combination Puzzle

25 Pages Posted: 27 Apr 2009

See all articles by Jeremy Smith

Jeremy Smith

University of Warwick - Department of Economics

Kenneth F. Wallis

University of Warwick - Department of Economics

Date Written: 0000

Abstract

This article presents a formal explanation of the forecast combination puzzle, that simple combinations of point forecasts are repeatedly found to outperform sophisticated weighted combinations in empirical applications. The explanation lies in the effect of finite-sample error in estimating the combining weights. A small Monte Carlo study and a reappraisal of an empirical study by Stock and Watson [Federal Reserve Bank of Richmond Economic Quarterly (2003) Vol. 89/3, pp. 71–90] support this explanation. The Monte Carlo evidence, together with a large-sample approximation to the variance of the combining weight, also supports the popular recommendation to ignore forecast error covariances in estimating the weight.

Suggested Citation

Smith, Jeremy P. and Wallis, Kenneth F., A Simple Explanation of the Forecast Combination Puzzle (0000). Oxford Bulletin of Economics and Statistics, Vol. 71, Issue 3, pp. 331-355, June 2009. Available at SSRN: https://ssrn.com/abstract=1395137 or http://dx.doi.org/10.1111/j.1468-0084.2008.00541.x

Jeremy P. Smith

University of Warwick - Department of Economics ( email )

Coventry CV4 7AL
United Kingdom

Kenneth F. Wallis

University of Warwick - Department of Economics ( email )

Coventry CV4 7AL
United Kingdom

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