IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

Predictive Systems: Living with Imperfect Predictors

  • LUBOS PÁSTOR
  • ROBERT F. STAMBAUGH

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

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 under "Related research" (further below) or search for a different version of it.

Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 64 (2009)
Issue (Month): 4 (08)
Pages: 1583-1628

as
in new window

Handle: RePEc:bla:jfinan:v:64:y:2009:i:4:p:1583-1628
Contact details of provider: Web page: http://www.afajof.org/

More information through EDIRC

Order Information: Web: http://www.afajof.org/membership/join.asp

References listed on IDEAS
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.:

as in new window
  1. Campbell, J.Y. & Ammer, J., 1991. "What Moves The Stock And Bond Markets? A Variance Decomposition For Long- Term Asset Returns," Papers 127, Princeton, Department of Economics - Financial Research Center.
  2. Lettau, Martin & Ludvigson, Sydney C., 2005. "Expected returns and expected dividend growth," Journal of Financial Economics, Elsevier, vol. 76(3), pages 583-626, June.
  3. Doron Avramov, 2004. "Stock Return Predictability and Asset Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 17(3), pages 699-738.
  4. Todd E. Clark & Kenneth D. West, 2005. "Approximately normal tests for equal predictive accuracy in nested models," Research Working Paper RWP 05-05, Federal Reserve Bank of Kansas City.
  5. 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, 02.
  6. 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, 08.
  7. Stambaugh, Robert F., 1999. "Predictive regressions," Journal of Financial Economics, Elsevier, vol. 54(3), pages 375-421, December.
  8. Michael Jansson & Marcelo J. Moreira, 2004. "Optimal Inference in Regression Models with Nearly Integrated Regressors," Harvard Institute of Economic Research Working Papers 2047, Harvard - Institute of Economic Research.
  9. 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.
  10. Conrad, Jennifer & Kaul, Gautam, 1988. "Time-Variation in Expected Returns," The Journal of Business, University of Chicago Press, vol. 61(4), pages 409-25, October.
  11. Luboš Pástor & Robert F. Stambaugh, 1999. "Comparing Asset Pricing Models: An Investment Perspective," CRSP working papers 497, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  12. John Y. Campbell & Motohiro Yogo, 2002. "Efficient Tests of Stock Return Predictability," Harvard Institute of Economic Research Working Papers 1972, Harvard - Institute of Economic Research.
  13. Robert F. Stambaugh, . "Analyzing Investments Whose Histories Differ in Length," Rodney L. White Center for Financial Research Working Papers 05-96, Wharton School Rodney L. White Center for Financial Research.
  14. 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 641-61, June.
  15. N. Gregory Mankiw & Matthew D. Shapiro, 1985. "Do We Reject Too Often? Small Sample Properties of Tests of Rational Expectations Models," NBER Technical Working Papers 0051, National Bureau of Economic Research, Inc.
  16. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
  17. Martin Lettau & Stijn Van Nieuwerburgh, 2006. "Reconciling the Return Predictability Evidence," NBER Working Papers 12109, National Bureau of Economic Research, Inc.
  18. 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.
  19. 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.
  20. Luboš Pástor & Robert F. Stambaugh, 2000. "The Equity Premium and Structural Breaks," CRSP working papers 519, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  21. Lubos Pastor & Meenakshi Sinha & Bhaskaran Swaminathan, 2006. "Estimating the Intertemporal Risk-Return Tradeoff Using the Implied Cost of Capital," NBER Working Papers 11941, National Bureau of Economic Research, Inc.
  22. Amit Goyal & Ivo Welch, 2004. "A Comprehensive Look at the Empirical Performance of Equity Premium Prediction," Yale School of Management Working Papers amz2412, Yale School of Management, revised 01 Jan 2006.
  23. 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.
  24. repec:cup:etheor:v:11:y:1995:i:5:p:1131-47 is not listed on IDEAS
  25. 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.
  26. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  27. Graham Elliott & James H. Stock, 1992. "Inference in Time Series Regression When the Order of Integration of a Regressor is Unknown," NBER Technical Working Papers 0122, National Bureau of Economic Research, Inc.
  28. 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.
  29. 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.
  30. Pastor, Lubos & Stambaugh, Robert F., 2002. "Investing in equity mutual funds," Journal of Financial Economics, Elsevier, vol. 63(3), pages 351-380, March.
  31. Owen Lamont, . "Earnings and Expected Returns," CRSP working papers 345, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  32. 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 1033-59.
  33. Amit Goyal & Ivo Welch, 2003. "Predicting the Equity Premium with Dividend Ratios," Management Science, INFORMS, vol. 49(5), pages 639-654, May.
  34. Shmuel Kandel & Robert F. Stambaugh, 1995. "On the Predictability of Stock Returns: An Asset-Allocation Perspective," NBER Working Papers 4997, National Bureau of Economic Research, Inc.
  35. Donald B. Keim & Robert F. Stambaugh, . "Predicting Returns in the Stock and Bond Markets," Rodney L. White Center for Financial Research Working Papers 15-85, Wharton School Rodney L. White Center for Financial Research.
  36. Klaas Baks & Andrew Metrick & Jessica Wachter, . "Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation," Rodney L. White Center for Financial Research Working Papers 18-99, Wharton School Rodney L. White Center for Financial Research.
  37. Jessica A. Wachter & Missaka Warusawitharana, 2007. "Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?," NBER Working Papers 13165, National Bureau of Economic Research, Inc.
  38. Lubo Pástor, . "Portfolio Selection and Asset Pricing Models," CRSP working papers 498, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  39. 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.).
  40. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
  41. 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 527-66.
  42. Campbell, John Y., 1987. "Stock returns and the term structure," Journal of Financial Economics, Elsevier, vol. 18(2), pages 373-399, June.
  43. repec:fth:pennfi:72 is not listed on IDEAS
  44. Andrew Ang & Monika Piazzesi, 2001. "A No-Arbitrage Vector Autoregression of Term Structure Dynamics with Macroeconomic and Latent Variables," NBER Working Papers 8363, National Bureau of Economic Research, Inc.
  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. John Y. Campbell & Samuel B. Thompson, 2005. "Predicting the Equity Premium Out of Sample: Can Anything Beat the Historical Average?," NBER Working Papers 11468, National Bureau of Economic Research, Inc.
  47. John H. Cochrane, 2006. "The Dog That Did Not Bark: A Defense of Return Predictability," NBER Working Papers 12026, National Bureau of Economic Research, Inc.
  48. Lior Menzly & Tano Santos & Pietro Veronesi, 2004. "Understanding Predictability," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 1-47, February.
  49. Avramov, Doron, 2002. "Stock return predictability and model uncertainty," Journal of Financial Economics, Elsevier, vol. 64(3), pages 423-458, June.
  50. 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.
  51. Andrew Ang & Geert Bekaert, 2001. "Stock Return Predictability: Is it There?," NBER Working Papers 8207, National Bureau of Economic Research, Inc.
  52. Lewellen, Jonathan, 2004. "Predicting returns with financial ratios," Journal of Financial Economics, Elsevier, vol. 74(2), pages 209-235, November.
  53. 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.
  54. repec:cup:etheor:v:10:y:1994:i:3-4:p:672-700 is not listed on IDEAS
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

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)

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 references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link 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 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.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.