IDEAS home Printed from https://ideas.repec.org/a/bla/jfinan/v64y2009i4p1583-1628.html
   My bibliography  Save this article

Predictive Systems: Living with Imperfect Predictors

Author

Listed:
  • LUBOS PÁSTOR
  • ROBERT F. STAMBAUGH

Abstract

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 expected returns with higher estimated precision. Copyright (c) 2009 the American Finance Association.

Suggested Citation

  • Lubos Pástor & Robert F. Stambaugh, 2009. "Predictive Systems: Living with Imperfect Predictors," Journal of Finance, American Finance Association, vol. 64(4), pages 1583-1628, August.
  • Handle: RePEc:bla:jfinan:v:64:y:2009:i:4:p:1583-1628
    as

    Download full text from publisher

    File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1540-6261.2009.01474.x
    File Function: link to full text
    Download Restriction: Access to full text is restricted to subscribers.

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    1. Martin Lettau & Stijn Van Nieuwerburgh, 2008. "Reconciling the Return Predictability Evidence," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1607-1652, July.
    2. Doron Avramov, 2004. "Stock Return Predictability and Asset Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 699-738.
    3. Campbell, John Y & Ammer, John, 1993. " What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Journal of Finance, American Finance Association, vol. 48(1), pages 3-37, March.
    4. Ivo Welch & Amit Goyal, 2008. "A Comprehensive Look at The Empirical Performance of Equity Premium Prediction," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1455-1508, July.
    5. Owen Lamont, 1998. "Earnings and Expected Returns," Journal of Finance, American Finance Association, vol. 53(5), pages 1563-1587, October.
    6. Lubos Pástor & Robert F. Stambaugh, 1999. "Costs of Equity Capital and Model Mispricing," Journal of Finance, American Finance Association, vol. 54(1), pages 67-121, February.
    7. Elliott, Graham & Stock, James H., 1994. "Inference in Time Series Regression When the Order of Integration of a Regressor is Unknown," Econometric Theory, Cambridge University Press, vol. 10(3-4), pages 672-700, August.
    8. Ang, Andrew & Piazzesi, Monika, 2003. "A no-arbitrage vector autoregression of term structure dynamics with macroeconomic and latent variables," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 745-787, May.
    9. Klaas P. Baks, 2001. "Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation," Journal of Finance, American Finance Association, vol. 56(1), pages 45-85, February.
    10. Clark, Todd E. & West, Kenneth D., 2006. "Using out-of-sample mean squared prediction errors to test the martingale difference hypothesis," Journal of Econometrics, Elsevier, vol. 135(1-2), pages 155-186.
    11. Michael Jansson & Marcelo J. Moreira, 2006. "Optimal Inference in Regression Models with Nearly Integrated Regressors," Econometrica, Econometric Society, vol. 74(3), pages 681-714, May.
    12. Lior Menzly & Tano Santos & Pietro Veronesi, 2004. "Understanding Predictability," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 1-47, February.
    13. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December.
    14. Lubos Pástor & Meenakshi Sinha & Bhaskaran Swaminathan, 2008. "Estimating the Intertemporal Risk-Return Tradeoff Using the Implied Cost of Capital," Journal of Finance, American Finance Association, vol. 63(6), pages 2859-2897, December.
    15. Erik Hjalmarsson, 2006. "Should we expect significant out-of-sample results when predicting stock returns?," International Finance Discussion Papers 855, Board of Governors of the Federal Reserve System (U.S.).
    16. Pastor, Lubos & Stambaugh, Robert F., 2002. "Investing in equity mutual funds," Journal of Financial Economics, Elsevier, vol. 63(3), pages 351-380, March.
    17. Conrad, Jennifer & Kaul, Gautam, 1988. "Time-Variation in Expected Returns," The Journal of Business, University of Chicago Press, vol. 61(4), pages 409-425, October.
    18. Nelson, Charles R & Kim, Myung J, 1993. " Predictable Stock Returns: The Role of Small Sample Bias," Journal of Finance, American Finance Association, vol. 48(2), pages 641-661, June.
    19. Lamoureux, Christopher G & Zhou, Guofu, 1996. "Temporary Components of Stock Returns: What Do the Data Tell Us?," Review of Financial Studies, Society for Financial Studies, vol. 9(4), pages 1033-1059.
    20. Jones, Christopher S. & Shanken, Jay, 2005. "Mutual fund performance with learning across funds," Journal of Financial Economics, Elsevier, vol. 78(3), pages 507-552, December.
    21. Lettau, Martin & Ludvigson, Sydney C., 2005. "Expected returns and expected dividend growth," Journal of Financial Economics, Elsevier, vol. 76(3), pages 583-626, June.
    22. Campbell, John Y, 1991. "A Variance Decomposition for Stock Returns," Economic Journal, Royal Economic Society, vol. 101(405), pages 157-179, March.
    23. Amit Goyal & Ivo Welch, 2003. "Predicting the Equity Premium with Dividend Ratios," Management Science, INFORMS, vol. 49(5), pages 639-654, May.
    24. Llubos Pástor, 2001. "The Equity Premium and Structural Breaks," Journal of Finance, American Finance Association, vol. 56(4), pages 1207-1239, August.
    25. Pastor, Lubos & Stambaugh, Robert F., 2000. "Comparing asset pricing models: an investment perspective," Journal of Financial Economics, Elsevier, vol. 56(3), pages 335-381, June.
    26. Stambaugh, Robert F., 1997. "Analyzing investments whose histories differ in length," Journal of Financial Economics, Elsevier, vol. 45(3), pages 285-331, September.
    27. John Y. Campbell & Samuel B. Thompson, 2005. "Predicting the Equity Premium Out of Sample: Can Anything Beat the Historical Average?," Harvard Institute of Economic Research Working Papers 2084, Harvard - Institute of Economic Research.
    28. repec:cup:etheor:v:10:y:1994:i:3-4:p:672-700 is not listed on IDEAS
    29. Wayne E. Ferson & Sergei Sarkissian & Timothy T. Simin, 2003. "Spurious Regressions in Financial Economics?," Journal of Finance, American Finance Association, vol. 58(4), pages 1393-1414, August.
    30. Kandel, Shmuel & Stambaugh, Robert F, 1996. " On the Predictability of Stock Returns: An Asset-Allocation Perspective," Journal of Finance, American Finance Association, vol. 51(2), pages 385-424, June.
    31. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
    32. Lubos Pástor, 2000. "Portfolio Selection and Asset Pricing Models," Journal of Finance, American Finance Association, vol. 55(1), pages 179-223, February.
    33. Campbell, John Y. & Yogo, Motohiro, 2006. "Efficient tests of stock return predictability," Journal of Financial Economics, Elsevier, vol. 81(1), pages 27-60, July.
    34. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
    35. Pastor, Lubos & Stambaugh, Robert F., 2002. "Mutual fund performance and seemingly unrelated assets," Journal of Financial Economics, Elsevier, vol. 63(3), pages 315-349, March.
    36. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
    37. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
    38. Clark, Todd E. & West, Kenneth D., 2007. "Approximately normal tests for equal predictive accuracy in nested models," Journal of Econometrics, Elsevier, vol. 138(1), pages 291-311, May.
    39. Gregory Mankiw, N. & Shapiro, Matthew D., 1986. "Do we reject too often? : Small sample properties of tests of rational expectations models," Economics Letters, Elsevier, vol. 20(2), pages 139-145.
    40. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
    41. K. J. Martijn Cremers, 2002. "Stock Return Predictability: A Bayesian Model Selection Perspective," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1223-1249.
    42. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-436, June.
    43. Wachter, Jessica A. & Warusawitharana, Missaka, 2009. "Predictable returns and asset allocation: Should a skeptical investor time the market?," Journal of Econometrics, Elsevier, vol. 148(2), pages 162-178, February.
    44. Avramov, Doron, 2002. "Stock return predictability and model uncertainty," Journal of Financial Economics, Elsevier, vol. 64(3), pages 423-458, June.
    45. Brandt, Michael W. & Kang, Qiang, 2004. "On the relationship between the conditional mean and volatility of stock returns: A latent VAR approach," Journal of Financial Economics, Elsevier, vol. 72(2), pages 217-257, May.
    46. Nicholas Barberis, 2000. "Investing for the Long Run when Returns Are Predictable," Journal of Finance, American Finance Association, vol. 55(1), pages 225-264, February.
    47. John H. Cochrane, 2008. "The Dog That Did Not Bark: A Defense of Return Predictability," Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1533-1575, July.
    48. repec:fth:pennfi:72 is not listed on IDEAS
    49. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
    50. Cavanagh, Christopher L. & Elliott, Graham & Stock, James H., 1995. "Inference in Models with Nearly Integrated Regressors," Econometric Theory, Cambridge University Press, vol. 11(05), pages 1131-1147, October.
    51. Stambaugh, Robert F., 1999. "Predictive regressions," Journal of Financial Economics, Elsevier, vol. 54(3), pages 375-421, December.
    52. Tano Santos & Pietro Veronesi, 2006. "Labor Income and Predictable Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 19(1), pages 1-44.
    53. repec:cup:etheor:v:11:y:1995:i:5:p:1131-47 is not listed on IDEAS
    54. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-566.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bla:jfinan:v:64:y:2009:i:4:p:1583-1628. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Wiley-Blackwell Digital Licensing) or (Christopher F. Baum). General contact details of provider: http://edirc.repec.org/data/afaaaea.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.