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Model Uncertainty, Thick Modelling and the predictability of Stock Returns

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Marco Aiolfi
Carlo Ambrogio Favero

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Abstract

Recent financial research has provided evidence on the predictability of asset returns. In this paper we consider the results contained in Pesaran-Timmerman (1995), hich provided evidence on predictability over the sample 1959-1992. We show that the extension of the sample to the ninetieth weakens considerably the statistical and economic significance of the predictability of stock returns based on earlier data. We propose an extension of their framework, based on the explicit consideration of model uncertainty under rich parameterizations for the predictive models. We propose a novel methodology to deal with model uncertainty based on ´´thick´´ modeling, i.e. on considering a multiplicity of predictive models rather than a single predictive model. We show that portfolio allocations based on a thick modelling strategy sistematically overperforms thin modelling.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 221.

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Handle: RePEc:igi:igierp:221

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  3. Ait-Sahalia, Y. & Brandt, M.W., 2001. "Variable Selection for Portfolio Choice," Papers 34, Manitoba - Department of Economics.
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  4. M. Hashem Pesaran & Allan Timmermann, 1995. "Predictability of Stock Returns: Robustness and Economic Significance," University of California at San Diego, Economics Working Paper Series 95-19, Department of Economics, UC San Diego.
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  5. Clive Granger & Allan Timmermann, 1999. "Data mining with local model specification uncertainty: a discussion of Hoover and Perez," Econometrics Journal, Royal Economic Society, vol. 2(2), pages 220-225.
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  7. Nicholas Barberis, 2000. "Investing for the Long Run when Returns Are Predictable," Journal of Finance, American Finance Association, vol. 55(1), pages 225-264, 02. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Pedro N. Rodríguez, & Simón Sosvilla-Rivero, 2006. "Forecasting Stock Price Changes: Is it Possible?," Working Papers 2006-22, FEDEA. [Downloadable!]
  2. Coe, P.J. & Pesaran, M.H. & Vahey, S.P., 2003. "Scope for Cost Minimization in Public Debt Management: the Case of the UK," Cambridge Working Papers in Economics 0338, Faculty of Economics, University of Cambridge. [Downloadable!]
  3. Massimo Guidolin & Carrie Fangzhou Na, 2007. "The economic and statistical value of forecast combinations under regime switching: an application to predictable U.S. returns," Working Papers 2006-059, Federal Reserve Bank of St. Louis. [Downloadable!]
  4. Pesaran, M.H. & Timmermann, A., 2004. "‘Real Time Econometrics’," Cambridge Working Papers in Economics 0432, Faculty of Economics, University of Cambridge. [Downloadable!]
    Other versions:
  5. M. Hashem Pesaran & Paolo Zaffaroni, 2004. "Model Averaging and Value-at-Risk Based Evaluation of Large Multi Asset Volatility Models for Risk Management," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
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