Asymmetric Loss Functions and the Rationality of Expected Stock Returns

Abstract

We combine the innovative approaches of Elliott, Komunjer, and Timmermann (2005) and Patton and Timmermann (2007) with a block bootstrap to analyze whether asymmetric loss functions can rationalize the S&P 500 return expectations of individual forecasters from the Livingston Surveys. Although the rationality of these forecasts has often been rejected, earlier studies rely on the assumption that positive and negative forecast errors of identical magnitude are equally important to forecasters. Allowing for homogenous asymmetric loss, our evidence still strongly rejects forecast rationality. However, if we allow for variation in asymmetric loss functions across forecasters, we not only find significant differences in preferences, but we can also often no longer reject forecast rationality. Our conclusions raise serious doubts about the homogeneous expectations assumption often made in asset pricing, portfolio construction and corporate finance models.

Keywords: financial markets, general loss functions, GMM block bootstrapping, Livingston Survey, price forecasting

JEL Classification: G11, G12, G15