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Market timing with aggregate and idiosyncratic stock volatilities

  • Hui Guo
  • Jason Higbee
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Guo and Savickas [2005] show that aggregate stock market volatility and average idiosyncratic stock volatility jointly forecast stock returns. In this paper, we quantify the economic significance of their results from the perspective of a portfolio manager. That is, we evaluate the performance, e.g., the Sharpe ratio and Jensen's alpha, of a mean-variance manager who tries to time the market based on those two variables. We find that, over the period 1968-2004, the associated market-timing strategy outperforms the buy-and-hold strategy, and the difference is statistically and economically significant.

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File URL: http://research.stlouisfed.org/wp/2005/2005-073.pdf
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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2005-073.

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Date of creation: 2006
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Handle: RePEc:fip:fedlwp:2005-073
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  1. Cumby, Robert E. & Modest, David M., 1987. "Testing for market timing ability : A framework for forecast evaluation," Journal of Financial Economics, Elsevier, vol. 19(1), pages 169-189, September.
  2. Hui Guo & Robert F. Whitelaw, 2003. "Uncovering the Risk-Return Relation in the Stock Market," NBER Working Papers 9927, National Bureau of Economic Research, Inc.
  3. Lettau, Martin & Ludvigson, Sydney, 1999. "Consumption, Aggregate Wealth and Expected Stock Returns," CEPR Discussion Papers 2223, C.E.P.R. Discussion Papers.
  4. Amit Goyal & Ivo Welch, 2003. "Predicting the Equity Premium with Dividend Ratios," Management Science, INFORMS, vol. 49(5), pages 639-654, May.
  5. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April.
  6. Bruce N. Lehmann, 1986. "Residual Risk Revisited," NBER Working Papers 1908, National Bureau of Economic Research, Inc.
  7. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  8. Robert C. Merton, 1980. "On Estimating the Expected Return on the Market: An Exploratory Investigation," NBER Working Papers 0444, National Bureau of Economic Research, Inc.
  9. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
  10. Miller, Edward M, 1977. "Risk, Uncertainty, and Divergence of Opinion," Journal of Finance, American Finance Association, vol. 32(4), pages 1151-68, September.
  11. Levy, Haim, 1978. "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio," American Economic Review, American Economic Association, vol. 68(4), pages 643-58, September.
  12. Malkiel, Burton & Campbell, John & Lettau, Martin & Xu, Yexiao, 2001. "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," Scholarly Articles 3128707, Harvard University Department of Economics.
  13. Chance, Don M. & Hemler, Michael L., 2001. "The performance of professional market timers: daily evidence from executed strategies," Journal of Financial Economics, Elsevier, vol. 62(2), pages 377-411, November.
  14. Hui Guo, 2003. "On the real-time forecasting ability of the consumption-wealth ratio," Working Papers 2003-007, Federal Reserve Bank of St. Louis.
  15. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  16. Jobson, J D & Korkie, Bob M, 1981. "Performance Hypothesis Testing with the Sharpe and Treynor Measures," Journal of Finance, American Finance Association, vol. 36(4), pages 889-908, September.
  17. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
  18. Lehmann, Bruce N., 1990. "Residual risk revisited," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 71-97.
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