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MAXIMIZING PREDICTABILITY IN THE STOCK AND BOND MARKETS

Published online by Cambridge University Press:  02 March 2005

ANDREW W. LO
Affiliation:
Sloan School of Management, Massachusetts Institute of Technology
A. CRAIG MACKINLAY
Affiliation:
The Wharton School, University of Pennsylvania
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We construct portfolios of stocks and bonds that are maximallypredictable with respect to a set of ex-ante observable economicvariables, and show that these levels of predictability arestatistically significant, even after controlling for data-snoopingbiases.We disaggregate the sources of predictability by usingseveral asset groups — sector portfolios, market-capitalizationportfolios, and stock/bond/utility portfolios — and find that thesources of maximal predictability shift considerably across assetclasses and sectors as the return horizon changes.Using threeout-of-sample measures of predictability — forecast errors, Merton'smarket-timing measure, and the profitability of asset-allocationstrategies based on maximizing predictability — we show that thepredictability of the maximally predictable portfolio is genuine andeconomically significant.

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Type
Research Article
Copyright
© 1997 Cambridge University Press