The Promises and Pitfalls of Machine Learning for Predicting Stock Returns

41 Pages Posted: 27 Mar 2020 Last revised: 31 Mar 2021

See all articles by Edward Leung

Edward Leung

Invesco

Harald Lohre

Invesco; Lancaster University Management School

David Mischlich

Invesco

Yifei Shea

Invesco

Maximilian Stroh

Quoniam Asset Management

Date Written: March 31, 2021

Abstract

Recent research suggests that machine learning models dominate traditional linear models in predicting cross-sectional stock returns. We confirm this finding when predicting one-month forward-looking returns based on a set of common stock characteristics, including predictors such as short-term reversal. Despite the statistical advantage of machine learning model predictions, we demonstrate that the economic gains tend to be more limited, and critically dependent on the ability to take risk and implement trades efficiently. Unlike traditional models, machine learning models have been somewhat more effective over the past decade at discerning valuable predictions from cross-sectional equity characteristics.

Keywords: Machine Learning, Data Science, Interpretable Machine Learning, Return Prediction, Cross-Section of Stock Returns, Gradient Boosting, Factor Investing

JEL Classification: G11, G12, G14, G15, G17

Suggested Citation

Leung, Edward and Lohre, Harald and Mischlich, David and Shea, Yifei and Stroh, Maximilian, The Promises and Pitfalls of Machine Learning for Predicting Stock Returns (March 31, 2021). Available at SSRN: https://ssrn.com/abstract=3546725 or http://dx.doi.org/10.2139/ssrn.3546725

Edward Leung

Invesco ( email )

An der Welle 5
Frankfurt am Main, 60322
Germany

Harald Lohre

Invesco ( email )

An der Welle 5
Frankfurt am Main, 60322
Germany

HOME PAGE: http://www.de.invesco.com/portal/site/de-de/home/ueber-uns/invesco-quantitative-strategies/

Lancaster University Management School

Bailrigg
Lancaster LA1 4YX
United Kingdom

HOME PAGE: http://www.lancaster.ac.uk/lums/people/harald-lohre

David Mischlich

Invesco ( email )

An der Welle 5
Frankfurt am Main, 60322
Germany

Yifei Shea

Invesco

100 Federal St
28th floor
Boston, MA MA 02110
United States

Maximilian Stroh (Contact Author)

Quoniam Asset Management ( email )

Frankfurt
Germany

HOME PAGE: http://www.quoniam.com

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