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On the Difficulty of Measuring Forecasting Skill in Financial Markets
Author(s) -
Satchell Stephen E.,
Williams Oliver J.
Publication year - 2015
Publication title -
journal of forecasting
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.543
H-Index - 59
eISSN - 1099-131X
pISSN - 0277-6693
DOI - 10.1002/for.2320
Subject(s) - ex ante , portfolio , context (archaeology) , asset allocation , asset (computer security) , economics , financial market , econometrics , process (computing) , computer science , financial economics , finance , macroeconomics , paleontology , computer security , biology , operating system
The use of correlation between forecasts and actual returns is commonplace in the literature, often used as a measurement of investors' skill. A prominent application of this is the concept of the information coefficient (IC). Not only can the IC be used as a tool to rate analysts and fund managers but it also represents an important parameter in the asset allocation and portfolio construction process. Nevertheless, a theoretical understanding of it has typically been limited to the partial equilibrium context where the investing activities of each agent have no effect on other market participants. In this paper we show that this can be an undesirable oversimplification and we demonstrate plausible circumstances in which conventional empirical measurements of IC can be highly misleading. We suggest that improved understanding of IC in a general equilibrium setting can lead to refined portfolio decision making ex ante and more informative analysis of performance ex post . Copyright © 2015 John Wiley & Sons, Ltd.