How to Dominate the Historical Average
Published in Review of Financial Studies, accepted, 2024., 2024
We present a novel methodology for the out-of-sample forecast of the equity premium. Our approach matches the stability of the historical average while conservatively utilizing a predictor’s capacity to improve forecast accuracy. We demonstrate that, theoretically and empirically, our method dominates the historical average in forecast performance. Our methodology establishes a simple yet powerful paradigm for exploiting the real-time equity premium predictability derived from a predictor. Applications of our method reveal that many predictors can forecast the equity premium, and that parameter estimates in previous studies add value to out-of-sample forecasts.