Forecasting Stock Returns with Model Uncertainty and Parameter Instability

45 Pages Posted: 21 Sep 2017 Last revised: 11 Apr 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: February 12, 2019

Abstract

We compare sophisticated models of forecasting stock returns that accommodate model uncertainty, including the new weighted-average least squares (WALS) technique. When estimated traditionally, our results confirm that the performance-based combination of individual predictors is superior. However, sophisticated models (especially WALS) improve dramatically once we combine them with the historical average and take parameter instability into account. Combining WALS with the historical average, for example, results in a statistically significant monthly out-of-sample R2 of 1.15% and annual utility gains of 2.55%. We obtain similar gains for predicting factor portfolios and 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 (February 12, 2019). Asian Finance Association (AsianFA) 2018 Conference. 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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