Do Return Prediction Models Add Economic Value?

37 Pages Posted: 22 Aug 2011 Last revised: 19 Feb 2014

See all articles by Tolga Cenesizoglu

Tolga Cenesizoglu

HEC Montreal - Department of Finance

Allan Timmermann

UCSD ; Centre for Economic Policy Research (CEPR)

Date Written: June 6, 2012

Abstract

We compare statistical and economic measures of forecasting performance across a large set of stock return prediction models with time-varying mean and volatility. We find that it is very common for models to produce higher out-of-sample mean squared forecast errors than a model assuming a constant equity premium, yet simultaneously add economic value when their forecasts are used to guide portfolio decisions. While there is generally a positive correlation between a return prediction model’s out-of-sample statistical performance and its ability to add economic value, the relation tends to be weak and only explains a small part of the cross-sectional variation in different models’ economic value.

Keywords: predictability of stock returns, mean squared forecast error, portfolio selection, probability distribution forecasts

Suggested Citation

Cenesizoglu, Tolga and Timmermann, Allan, Do Return Prediction Models Add Economic Value? (June 6, 2012). Journal of Banking and Finance, Vol. 36, No. 11, 2012. Available at SSRN: https://ssrn.com/abstract=1913736 or http://dx.doi.org/10.2139/ssrn.1913736

Tolga Cenesizoglu (Contact Author)

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

HOME PAGE: http://www.hec.ca/en/profs/tolga.cenesizoglu.html

Allan Timmermann

UCSD ( email )

9500 Gilman Drive
La Jolla, CA 92093-0553
United States
858-534-0894 (Phone)

HOME PAGE: http://rady.ucsd.edu/people/faculty/timmermann/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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