Do Return Prediction Models Add Economic Value?
37 Pages Posted: 22 Aug 2011 Last revised: 19 Feb 2014
Date Written: June 6, 2012
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
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