Small Levels of Predictability and Large Economic Gains
Posted: 25 May 2003
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Small Levels of Predictability and Large Economic Gains
Abstract
Small-return predictability in the stock market has been widely documented in empirical studies, yet little has been written on its economic importance. This paper examines the issue through profitability on a trading strategy that utilizes small levels of predictability and analyzes the statistical distribution for returns achieved under such a strategy. Our results suggest that small-return predictability is economically significant in the sense that such trading strategies not only yield high returns but also are less risky under a fat tail distribution assumption. Quantitatively, we demonstrate that such a strategy could have doubled the market return for the period 1952 to 1998. We investigate reliability of our results through simulation and bootstrapping.
Keywords: Conditional expectation, Economic significance, Predictability, Student-t distribution, Trading strategy
JEL Classification: C16, G10, G14
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