51 Pages Posted: 19 Feb 2007 Last revised: 13 Dec 2011
Date Written: July 21, 2008
We develop a framework for estimating expected returns - a predictive system - that allows predictors to be imperfectly correlated with the conditional expected return. When predictors are imperfect, the estimated expected return depends on past returns in a manner that hinges on the correlation between unexpected returns and innovations in expected returns. We find empirically that prior beliefs about this correlation, which is most likely negative, substantially affect estimates of expected returns as well as various inferences about predictability, including assessments of a predictor's usefulness. Compared to standard predictive regressions, predictive systems deliver different and more precise estimates of expected returns.
Keywords: predictability, expected stock return, state space model, predictive system, predictive regression, imperfect predictors, Bayesian
JEL Classification: G1
Suggested Citation: Suggested Citation
Pastor, Lubos and Stambaugh, Robert F., Predictive Systems: Living with Imperfect Predictors (July 21, 2008). CRSP Working Paper No. 617; EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=953272 or http://dx.doi.org/10.2139/ssrn.953272