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Unexpected opportunities in misspecified predictive regressions

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  • Coqueret, Guillaume
  • Deguest, Romain

Abstract

This article documents surprising learning patterns that can occur under model misspecification. An agent resorts to predictive regressions and fails to take into account autocorrelation in the dependent variable. Remarkably, when the dependent and independent variables are uncorrelated, we find cases for which the resulting out-of-sample R2 is well above zero, which benefits the agent, in spite of the erroneous model. We refer to them as instances of unexpected opportunity. When both variables exhibit high levels of persistence, we reveal the existence of counter-intuitive configurations for which the R2increases when the absolute correlation between the series decreases. Our theoretical results are confirmed by extensive simulations and complemented by an empirical exercise of equity premium prediction for which we use 15 predictors commonly referenced in the economic literature.

Suggested Citation

  • Coqueret, Guillaume & Deguest, Romain, 2024. "Unexpected opportunities in misspecified predictive regressions," European Journal of Operational Research, Elsevier, vol. 318(2), pages 686-700.
    • Handle: RePEc:eee:ejores:v:318:y:2024:i:2:p:686-700
    DOI: 10.1016/j.ejor.2024.05.044
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    More about this item

    Keywords

    Predictive regression; Model misspecification; Spurious accuracy; Short samples;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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