NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Predictive Systems: Living with Imperfect Predictors

Lubos Pastor, Robert F. Stambaugh

NBER Working Paper No. 12814
Issued in January 2007
NBER Program(s):   AP

The standard regression approach to modeling return predictability seems too restrictive in one way but too lax in another. A predictive regression models expected returns as an exact linear function of a given set of predictors but does not exploit the likely economic property that innovations in expected returns are negatively correlated with unexpected returns. We develop an alternative framework - a predictive system - that accommodates imperfect predictors and beliefs about that negative correlation. In this framework, the predictive ability of imperfect predictors is supplemented by information in lagged returns as well as lags of the predictors. Compared to predictive regressions, predictive systems deliver different and substantially more precise estimates of expected returns as well as different assessments of a given predictor's usefulness.

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Document Object Identifier (DOI): 10.3386/w12814

Published: 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.

This paper was subsequently revised as NBER working paper w13804, Predictive Systems: Living with Imperfect Predictors, Lubos Pastor, Robert F. Stambaugh
Users who downloaded this paper also downloaded these:
Pastor and Stambaugh w13804 Predictive Systems: Living with Imperfect Predictors
 
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