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How useful are historical data for forecasting the long-run equity return distribution?

  • John M. Maheu

    ()

    (University of Toronto, Canada and The Rimini Centre for Economics Analysis, Rimini, Italy.)

  • Thomas H. McCurdy

    ()

    (University of Toronto, Canada)

We provide an approach to forecasting the long-run (unconditional) distribution of equity returns making optimal use of historical data in the presence of structural breaks. Our focus is on learning about breaks in real time and assessing their impact on out-of-sample density forecasts. Forecasts use a probability-weighted average of submodels, each of which is estimated over a different historyof data. The paper illustrates the importance of uncertainty about structural breaks and the value of modeling higher-order moments of excess returns when forecasting the return distribution and its moments. The shape of the long-run distribution and the dynamics of the higher-order moments are quite different from those generated by forecasts which cannot capture structural breaks. The empirical results strongly reject ignoring structural change in favor of our forecasts which weight historical data to accommodate uncertainty about structural breaks. We also strongly reject the common practice of using a fixed-length moving window. These differences in long-run forecasts have implications for many financial decisions, particularly for risk management and long-run investment decisions.

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Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 19-07.

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Date of creation: Jul 2007
Date of revision: Jul 2007
Handle: RePEc:rim:rimwps:19-07
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