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

John Maheu and Thomas McCurdy

Working Papers from University of Toronto, Department of Economics

Abstract: 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 history of 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.

Keywords: density forecasts; structural change; model risk; parameter uncertainty; Bayesian learning; market returns (search for similar items in EconPapers)
JEL-codes: C11 C51 C53 (search for similar items in EconPapers)
Pages: 45 pages
Date: 2007-06-28
New Economics Papers: this item is included in nep-ecm, nep-ets, nep-for, nep-lab and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Related works:
Journal Article: How Useful are Historical Data for Forecasting the Long-Run Equity Return Distribution? (2009)
Working Paper: How useful are historical data for forecasting the long-run equity return distribution? (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:tor:tecipa:tecipa-293

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