Correlated Errors: Why a Monotone Relationship between Forecast Precision and Trading Profitability May Not Hold

25 Pages Posted: 5 Jul 2012

See all articles by Jochen Lawrenz

Jochen Lawrenz

University of Innsbruck

Alex Weissensteiner

Free University of Bolzano Bozen

Date Written: June/July 2012

Abstract

This paper argues that the relation between financial analysts’ earnings forecast accuracy and their recommendation profitability has to be augmented by the extent of commonality in their forecast errors. We show that while accuracy is positively related to expected performance, the correlation in forecasting errors has a negative impact. This implies that a monotonic relationship between ex ante identifiable forecast accuracy and ex post recommendation profitability does not need to hold. Thus, agents may be better off by making comparatively large but less correlated errors, than by making precise but highly correlated forecasts.

Keywords: forecast accuracy, analysts’ recommendation profitability, learning, Kalman filter

Suggested Citation

Lawrenz, Jochen and Weissensteiner, Alex, Correlated Errors: Why a Monotone Relationship between Forecast Precision and Trading Profitability May Not Hold (June/July 2012). Journal of Business Finance & Accounting, Vol. 39, Issue 5‐6, pp. 675-699, 2012. Available at SSRN: https://ssrn.com/abstract=2100701 or http://dx.doi.org/10.1111/j.1468-5957.2012.02291.x

Jochen Lawrenz (Contact Author)

University of Innsbruck ( email )

Universitätsstraße 15
Innsbruck, Innsbruck 6020
Austria
++43-512-507-7582 (Phone)

Alex Weissensteiner

Free University of Bolzano Bozen ( email )

Universitätsplatz 1
Bolzano, 39100
+39 0471 013496 (Phone)

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