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Market timing with aggregate and idiosyncratic stock volatilities

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  • Hui Guo
  • Jason Higbee
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Abstract

Guo and Savickas [2005] show that aggregate stock market volatility and average idiosyncratic stock volatility jointly forecast stock returns. In this paper, we quantify the economic significance of their results from the perspective of a portfolio manager. That is, we evaluate the performance, e.g., the Sharpe ratio and Jensen's alpha, of a mean-variance manager who tries to time the market based on those two variables. We find that, over the period 1968-2004, the associated market-timing strategy outperforms the buy-and-hold strategy, and the difference is statistically and economically significant.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2005-073.

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Date of creation: 2006
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Handle: RePEc:fip:fedlwp:2005-073

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Keywords: Stock exchanges;

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  1. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
  2. Bruce N. Lehmann, 1986. "Residual Risk Revisited," NBER Working Papers 1908, National Bureau of Economic Research, Inc.
  3. John Y. Campbell, 2001. "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," Journal of Finance, American Finance Association, vol. 56(1), pages 1-43, 02.
  4. Jobson, J D & Korkie, Bob M, 1981. "Performance Hypothesis Testing with the Sharpe and Treynor Measures," Journal of Finance, American Finance Association, vol. 36(4), pages 889-908, September.
  5. Lehmann, Bruce N., 1990. "Residual risk revisited," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 71-97.
  6. Hui Guo & Robert F. Whitelaw, 2003. "Uncovering the Risk-Return Relation in the Stock Market," NBER Working Papers 9927, National Bureau of Economic Research, Inc.
  7. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April.
  8. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  9. Martin Lettau, 2001. "Consumption, Aggregate Wealth, and Expected Stock Returns," Journal of Finance, American Finance Association, vol. 56(3), pages 815-849, 06.
  10. Robert C. Merton, 1980. "On Estimating the Expected Return on the Market: An Exploratory Investigation," NBER Working Papers 0444, National Bureau of Economic Research, Inc.
  11. Levy, Haim, 1978. "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio," American Economic Review, American Economic Association, vol. 68(4), pages 643-58, September.
  12. Amit Goyal & Ivo Welch, 2003. "Predicting the Equity Premium with Dividend Ratios," Management Science, INFORMS, vol. 49(5), pages 639-654, May.
  13. Miller, Edward M, 1977. "Risk, Uncertainty, and Divergence of Opinion," Journal of Finance, American Finance Association, vol. 32(4), pages 1151-68, September.
  14. Cumby, Robert E. & Modest, David M., 1987. "Testing for market timing ability : A framework for forecast evaluation," Journal of Financial Economics, Elsevier, vol. 19(1), pages 169-189, September.
  15. Hui Guo, 2003. "On the real-time forecasting ability of the consumption-wealth ratio," Working Papers 2003-007, Federal Reserve Bank of St. Louis.
  16. Chance, Don M. & Hemler, Michael L., 2001. "The performance of professional market timers: daily evidence from executed strategies," Journal of Financial Economics, Elsevier, vol. 62(2), pages 377-411, November.
  17. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  18. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
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