Summary of the Paper Entitled ‘The Mean Squared Prediction Error Paradox’

15 Pages Posted: 3 Mar 2021

See all articles by Pablo M. Pincheira

Pablo M. Pincheira

Adolfo Ibanez University - School of Business

Nicolas Hardy

Universidad Finis Terrae

Date Written: December 29, 2020

Abstract

This is a summary of the paper entitled: “The Mean Squared Prediction Error Paradox”. In that paper, we show that traditional comparisons of Mean Squared Prediction Error (MSPE) between two competing forecasts may be highly controversial. This is so because when some specific conditions of efficiency are not met, the forecast displaying the lowest MSPE will also display the lowest correlation with the target variable. Given that violations of efficiency are usual in the forecasting literature, this opposite behavior in terms of accuracy and correlation with the target variable may be a fairly common empirical finding that we label here as "the MSPE Paradox." We characterize "Paradox zones" in terms of differences in correlation with the target variable and conduct some simple simulations to show that these zones may be non-empty sets. Finally, we illustrate the relevance of the Paradox with two empirical applications.

Keywords: Mean Squared Prediction Error, Correlation, Forecasting, Time Series, Random Walk.

JEL Classification: C52, C53, G17, E270, E370, F370, L740, O180, R310

Suggested Citation

Pincheira, Pablo M. and Hardy, Nicolas, Summary of the Paper Entitled ‘The Mean Squared Prediction Error Paradox’ (December 29, 2020). Available at SSRN: https://ssrn.com/abstract=3756747 or http://dx.doi.org/10.2139/ssrn.3756747

Pablo M. Pincheira (Contact Author)

Adolfo Ibanez University - School of Business ( email )

Diagonal Las Torres 2640
Peñalolén
Santiago
Chile

Nicolas Hardy

Universidad Finis Terrae ( email )

Av. Pedro de Valdivia 1509
Ñuñoa
Santiago, Santiago
Chile

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