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Better Predictions Lead To Better Returns (Garbage In – Garbage Out)
In this article, Cameron Hight discusses the correlation of actual and forecasted returns for positions that under/overperformed optimal.
Not every position is better off following the model position size (optimal) determined by Alpha Theory. However, the times when optimal outperforms are associated with higher forecast accuracy. If you put better forecasts into the model, the model does better. This is a straightforward demonstration of Garbage In-Garbage Out.
Correlation of Actual and Forecasted Returns for Positions that Under/Overperformed Optimal
Models are data dependent. When good data is input in the model, the model has higher predictive power. Bad data in and, well, it doesn’t have the same edge. The correlations hold if we expand into quartiles.
Correlation of Actual and Forecasted Returns for Positions that Under/Overperformed Optimal
And largely holds for deciles:
Correlation of Actual and Forecasted Returns for Positions that Under/Overperformed Optimal
What you’ll notice is that the correlation overall between actual and forecasted returns is fairly small with the highest decile showing an 18% correlation. Even though the signal is faint, it is strong enough to power a model that produces positive returns.
As the data shows, it is worth taking the time to measure your historical forecasting skill. If you have positive forecasting skill, then a simple model can dramatically improve results.
