TY - JOUR AU - Pastor,Lubos AU - Stambaugh,Robert F. TI - Predictive Systems: Living with Imperfect Predictors JF - National Bureau of Economic Research Working Paper Series VL - No. 13804 PY - 2008 Y2 - February 2008 UR - http://www.nber.org/papers/w13804 L1 - http://www.nber.org/papers/w13804.pdf N1 - Author contact info: Lubos Pastor University of Chicago Booth School of Business 5807 South Woodlawn Ave Chicago, IL 60637 Tel: 773/834-4080 Fax: NA E-Mail: lubos.pastor@chicagobooth.edu Robert F. Stambaugh Finance Department The Wharton School University of Pennsylvania Philadelphia, PA 19104-6367 Tel: 215/898-5734 Fax: 215/898-6200 E-Mail: stambaugh@wharton.upenn.edu AB - 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. ER -