Shrinking return forecasts

Li Liu, Zhiyuan Pan and Yudong Wang

The Financial Review, 2022, vol. 57, issue 3, 641-661

Abstract: We develop a new approach that shrinks a given model forecast to the benchmark model forecast in order to improve forecasting performance. Simulation results show the superior performance of our approach, relative to popular methods such as forecast combination and the robustness to model misspecification. We apply our method to forecasting the returns on the S&P 500 index and find significant predictability when shrinking the principal component (PC) regression forecasts based on statistical and economic evaluation criteria. The forecast improvement from our shrinkage approach can be explained by the ability of its hyperparameters to be better predict real economic changes.

Date: 2022
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