Blackwell Reference Online

Extract

The predictability of financial markets has engaged the attention of both market professionals and academic economists for many years, but has also attracted the interest of numerous “amateur” investors, whether gifted or otherwise. The benefits of being able to accurately forecast movements in financial markets are aptly demonstrated by the example presented by Andrew Lo (1997) , who contrasted the returns from investing $1 in January 1926 in one-month U.S. Treasury bills with that of investing $1 at the same time in the S&P 500 stock market index. If the proceeds were reinvested each month, then the $1 investment in Treasury bills would have grown to $14 by December 1996, while the same investment in the S&P 500 would have been worth $1,371. But the greater returns obtained from investing in the stock rather than the bond market is not the point of the example, for suppose that at the start of each month the investor was able to forecast correctly which of these two investments would yield a higher return for that month, and acted on this forecast by switching the running total of his investment into the higher-yielding asset. Ignoring transaction costs, such a “perfect foresight” investment strategy would have been worth $2,296,183,456 by December 1996. Obviously, few, if any, investors have perfect foresight, but Lo's point was that even a modest ability to forecast ... log in or subscribe to read full text