A Three-Stage Procedure for Predicting Stock Returns

Bharat Sarath and Yixun Zhou

Chapter 7 in Handbook of Investment Analysis, Portfolio Management, and Financial Derivatives:In 4 Volumes, 2024, pp 235-260 from World Scientific Publishing Co. Pte. Ltd.

Abstract: In this chapter, we apply a three-stage approach using an intermediate classification period between the estimation and test periods. In the intermediate period, we stratify individual firms into deciles based on the predictive power of the Carhart 4-factor model, measured by the out-of-sample R-squared prediction in this period. Our motive for this stratification is that firms with poor out-of-sample predictive power of the estimated model are likely to suffer from coeffcient instability and that these instabilities will result in a mismeasurement of expected returns in the test period. The empirical results show that lower predictive power deciles have larger averaged absolute changes of estimated coeffcients, which is our proxy for coeffcient instability, and lower averaged out-of-sample R-squared in the test period.

Keywords: Financial Accounting; Financial Auditing; Mutual Funds; Hedge Funds; Asset Pricing; Options; Portfolio Analysis; Risk Management; Investment Analysis; Momentum Analysis; Behavior Analysis; Futures; Index Futures; CDCs; Financial Econometrics; Statistics; Financial Derivatives; Financial Accounting (search for similar items in EconPapers)
JEL-codes: G1 G11 G12 G3 M41 M42 (search for similar items in EconPapers)
Date: 2024
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