Forecasting Stock Returns with Model Uncertainty and Parameter Instability

35 Pages Posted: 21 Sep 2017 Last revised: 8 Dec 2019

See all articles by Hongwei Zhang

Hongwei Zhang

Tilburg University - TIAS School for Business and Society; Central University of Finance and Economics (CUFE)

Qiang He

Central University of Finance and Economics (CUFE)

Ben Jacobsen

Tilburg University - TIAS School for Business and Society; Massey University

Fuwei Jiang

Central University of Finance and Economics (CUFE)

Date Written: September 16, 2019

Abstract

We compare several representative sophisticated model averaging and variable selection techniques of forecasting stock returns. When estimated traditionally, our results confirm that the simple combination of individual predictors is superior. However, sophisticated models improve dramatically once we combine them with the historical average and take parameter instability into account. An equal weighted combination of the historical average with the standard multivariate predictive regression estimated using the average windows method, for example, achieves a statistically significant monthly out-of-sample R2 of 1.10% and annual utility gains of 2.34%. We obtain similar gains for predicting future macro economic conditions.

Keywords: Market Efficiency, Asset Pricing, Equity Premia Predictability, Forecast Combination, Model Uncertainty, Parameter Instability, WALS

JEL Classification: G17, G12, G02, C58

Suggested Citation

Zhang, Hongwei and He, Qiang and Jacobsen, Ben and Jiang, Fuwei, Forecasting Stock Returns with Model Uncertainty and Parameter Instability (September 16, 2019). Journal of Applied Econometrics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3039844 or http://dx.doi.org/10.2139/ssrn.3039844

Hongwei Zhang (Contact Author)

Tilburg University - TIAS School for Business and Society ( email )

Warandelaan 2
TIAS Building
Tilburg, Noord Brabant 5037 AB
Netherlands

Central University of Finance and Economics (CUFE)

39 South College Road
Haidian District
Beijing, 100081
China

Qiang He

Central University of Finance and Economics (CUFE)

39 South College Road
Haidian District
Beijing, 100081
China

Ben Jacobsen

Tilburg University - TIAS School for Business and Society ( email )

Warandelaan 2
TIAS Building
Tilburg, Noord Brabant 5037 AB
Netherlands

Massey University ( email )

Auckland
New Zealand

Fuwei Jiang

Central University of Finance and Economics (CUFE) ( email )

39 South College Road
Haidian District
Beijing, Beijing 100081
China

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