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Predictive Systems: Living with Imperfect Predictors

  • Lubos Pastor
  • 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 and more precise estimates of expected returns.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13804.

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Date of creation: Feb 2008
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Publication status: published as Lubos Pástor & Robert F. Stambaugh, 2009. "Predictive Systems: Living with Imperfect Predictors," Journal of Finance, American Finance Association, vol. 64(4), pages 1583-1628, 08.
Handle: RePEc:nbr:nberwo:13804
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