On the Economic Significance of Stock Return Predictability

Review of Finance

113 Pages Posted: 10 May 2019 Last revised: 24 Mar 2022

See all articles by Scott Cederburg

Scott Cederburg

University of Arizona - Department of Finance

Travis L. Johnson

The University of Texas at Austin

Michael S. O'Doherty

University of Missouri at Columbia - Department of Finance

Date Written: March 24, 2022

Abstract

We study the effects of time-varying volatility and investment horizon on the economic sig-
nificance of stock market return predictability from the perspective of Bayesian investors. Using
a vector autoregression framework with stochastic volatility in market returns and predictor
variables, we assess a broad set of 26 predictors with both in-sample and out-of-sample designs.
Volatility and horizon are critically important for assessing return predictors, as these factors
affect how an investor learns about predictability and how she chooses to invest based on re-
turn forecasts. We find that statistically strong predictors can be economically unimportant
if they tend to take extreme values in high volatility periods, have low persistence, or follow
distributions with fat tails. Several popular predictors exhibit these properties such that their
impressive statistical results do not translate into large economic gains. We also demonstrate
that incorporating stochastic volatility leads to substantial utility gains in real-time forecasting.

Keywords: Market return predictability, Bayesian investors, Stochastic volatility, Multiperiod horizons

JEL Classification: G10, G11, G12

Suggested Citation

Cederburg, Scott and Johnson, Travis L. and O'Doherty, Michael S., On the Economic Significance of Stock Return Predictability (March 24, 2022). Review of Finance, Available at SSRN: https://ssrn.com/abstract=3372629 or http://dx.doi.org/10.2139/ssrn.3372629

Scott Cederburg (Contact Author)

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States

Travis L. Johnson

The University of Texas at Austin ( email )

2110 Speedway Stop B6600
Austin, TX Texas 78712
United States
6178995325 (Phone)

HOME PAGE: http://travislakejohnson.com

Michael S. O'Doherty

University of Missouri at Columbia - Department of Finance ( email )

Robert J. Trulaske, Sr. College of Business
401 Cornell Hall
Columbia, MO 65211
United States

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