Mean reversion and market predictability

Document description

This paper examines some arguments for the predictability of share price and currency movements. We examine data from 1976-2001, and reproduce some classical regression results. On further investigation, we find biases in the classical estimation procedures. These biases are likely to overstate the extent of apparent market predictability. The biases are also present in the standard calibration processes for many popular stochastic asset models. They lead to an under-statement of investment risk, particularly for equity investment over long horizons, and an overstatement of the extent to which investors can improve returns by dynamic sector switches. Efficient market models provide a simpler, robust and prudent alternative approach for risk management and control purposes. Risk Premiums ­ The Two Points of View The return on a stock market or currency can be expressed as a risk free return plus a risk premium. There are two schools of thought on risk premiums. One school argues that market movements are, to some degree predictable.