Bayesian Model Averaging in the Presence of Structural Breaks

Abstract

This paper develops a return forecasting methodology that allows for instability in the relationship between stock returns and predictor variables, for model uncertainty, and for parameter estimation uncertainty. The predictive regression specification that is put forward allows for occasional structural breaks of random magnitude in the regression parameters, and for uncertainty about the inclusion of forecasting variables, and about the parameter values by employing Bayesian Model Averaging. The implications of these three sources of uncertainty, and their relative importance, are investigated from an active investment management perspective. It is found that the economic value of incorporating all three sources of uncertainty is considerable. A typical in vestor would be willing to pay up to several hundreds of basis points annually to switch from a passive buy-and-hold strategy to an active strategy based on a return forecasting model that allows for model and parameter uncertainty as well as structural breaks in the regression parameters.

Keywords: Stock return predictability, model uncertainty, Bayesian model averaging, structural breaks, portfolio selection

JEL Classification: G11, G12, C11