Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?

By Jessica A. Wachter, Missaka Warusawitharana. 2009

151 citations recorded by the source corpus.

Are excess returns predictable and if so, what does this mean for investors? Previous literature has tended toward two polar viewpoints: that predictability is useful only if the statistical evidence for it is incontrovertible, or that predictability should affect portfolio choice, even if the evidence is weak according to conventional measures. This paper models an intermediate view: that both data and theory are useful for decision-making. We investigate optimal portfolio choice for an investor who is skeptical about the amount of predictability in the data. Skepticism is modeled as an informative prior over the improvement in the Sharpe ratio generated by using the predictor variable. We find that the evidence is sufficient to convince even an investor with a highly skeptical prior to vary his portfolio on the basis of the dividend-price ratio and the yield spread. The resulting weights are less volatile, and, as we show, deliver superior out-of-sample performance compared with weights implied by diffuse priors, dogmatic priors, and ordinary least squares regression.

Subfields: Accounting, Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/94a71301fb2adff3a3b88d087407679677dd07fb

How researchers see this paper

The researchers whose trusted networks rank it highest, strongest advocate first. Every researcher gets a different order.

In Accounting

In Economics and Econometrics

In Finance

Citations in the corpus

Chapter 21 - Household Finance: An Emerging Field∗ (2013, unknown): “57 Notice that parameter uncertainty and learning effects offset mean-reversion in stock returns, although the magnitude of this is disputed (Barberis, 2000; Wachter and Warusawitharana, 2009).”
Sequential Learning, Predictability, and Optimal Portfolio Returns: Sequential Learning, Predictability, and Optimal Portfolio Returns (2014, unknown): “Wachter and Warusawitharana (2009) consider a Bayesian multi-asset portfolio problem with long term bonds, aggregate equity returns, and the risk-free rate.”
Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average? (2008, unknown): “One obvious possibility is a Bayesian approach with priors centered either on a model with a constant expected stock return, as in Wachter and Warusawitharana (2006), or on a valuation model with constant or slowly changing protability and payout ratios of the sort we have explored in this paper.”
On the Timing and Pricing of Dividends (2011, unknown): “(15) This model departs from the Lucas model in two important ways. First, the CRRA preferences are generalized to Epstein and Zin (1989) preferences to separate the coefficient of relative risk aversion from the elasticity of intertemporal substitution.”
Viewpoint: Estimating the Equity Premium (2008, unknown): “Several recent papers have done this, notably Pastor and Stambaugh (2007) and Wachter and Warusawitharana (2007).”
Learning in Financial Markets (2009, background): “Empirical Bayesian studies that analyze return predictability include Kandel and Stambaugh (1996), Stambaugh (1999), Avramov (2002), Cremers (2002), Avramov and Chordia (2006), Pástor and Stambaugh (2009), Wachter and Warusawitharana (2009), and others.”
Predicting market returns using aggregate implied cost of capital (2013, unknown): “…the realized utility gains for a mean-variance investor (see Marquering and Verbeek (2004); Campbell and Thompson (2008); Welch and Goyal (2008); Wachter and Warusawitharana (2009); 23The most popular method for testing these kinds of hypotheses is the Diebold and Mariano (1995) and West (1996)…”
Predictability of stock returns and asset allocation under structural breaks (2011, unknown): “An alternative way to evaluate the importance of return predictability is to conduct a recursive out-of-sample analysis as is done by Dangl and Halling (2008), Johannes, Korteweg, and Polson (2009) and Wachter and Warusawitharana (2009).”