The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

FORECASTING STOCK RETURNS, RISKS, AND TRANSACTION COSTS

Developing good forecasts is the first and perhaps most critical step in the investment process. Without good forecasts, the difficult task of forming superior portfolios becomes nearly impossible. In this section we discuss how to use a quantitative approach to generate forecasts of stock returns, risks, and transaction costs. These forecasts are then used in the portfolio construction step described in the next section.

It should be noted that some portfolio managers do not develop explicit forecasts of returns, risks, and transaction costs. Instead, they map a variety of individual stock characteristics directly into portfolio holdings. However, there are limitations with this abbreviated approach. Because the returns and risks corresponding to the various characteristics are not clearly identified, it is difficult to ensure the weights placed on the characteristics are appropriate. Further, measuring risk at the portfolio level is awkward without reliable estimates of the risks of each stock, especially the correlations between stocks. Similarly, controlling turnover is hard when returns and transaction costs are not expressed in consistent units. And, of course, it is difficult to explain a process that comprises a single integrated step.

Forecasting Returns

The process of building a quantitative return-forecasting model can be divided into four closely linked steps: (1) identifying a set of potential return forecasting ...