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Return Predictability, Model Uncertainty, and Robust Investment

Author

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  • Manuel Lukas

    (Aarhus University and CREATES)

Abstract

Stock return predictability is subject to great uncertainty. In this paper we use the model confidence set approach to quantify uncertainty about expected utility from investment, accounting for potential return predictability. For monthly US data and six representative return prediction models, we find that confidence sets are very wide, change significantly with the predictor variables, and frequently include expected utilities for which the investor prefers not to invest. The latter motivates a robust investment strategy maximizing the minimal element of the confidence set. The robust investor allocates a much lower share of wealth to stocks compared to a standard investor.

Suggested Citation

  • Manuel Lukas, 2011. "Return Predictability, Model Uncertainty, and Robust Investment," CREATES Research Papers 2011-42, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2011-42
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    File URL: https://repec.econ.au.dk/repec/creates/rp/11/rp11_42.pdf
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    More about this item

    Keywords

    Return predictability; Model uncertainty; Model confidence set; Portfolio choice; Loss function;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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