Return Predictability, Model Uncertainty, and Robust Investment
AbstractStock return predictability is subject to great uncertainty. In this paper we use the model confidence set approach to quantify uncertainty about expected utility from investment, accounting for potential return predictability. For monthly US data and six representative return prediction models, we find that confidence sets are very wide, change significantly with the predictor variables, and frequently include expected utilities for which the investor prefers not to invest. The latter motivates a robust investment strategy maximizing the minimal element of the confidence set. The robust investor allocates a much lower share of wealth to stocks compared to a standard investor.
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Bibliographic InfoPaper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2011-42.
Date of creation: 26 Nov 2011
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Web page: http://www.econ.au.dk/afn/
Return predictability; Model uncertainty; Model confidence set; Portfolio choice; Loss function;
Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
- C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
- C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-12-19 (All new papers)
- NEP-ECM-2011-12-19 (Econometrics)
- NEP-FOR-2011-12-19 (Forecasting)
- NEP-UPT-2011-12-19 (Utility Models & Prospect Theory)
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