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Predictive Systems: Living with Imperfect Predictors

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  • ĽUBOŠ 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.

Suggested Citation

  • Ľuboš 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
    DOI: 10.1111/j.1540-6261.2009.01474.x
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    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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