Methodologies for Isolating and Assessing the Portfolio Performance Potential of Stock Return Forecast Models with an Illustration


This paper develops and illustrates methodology for full sample assessment of the potential ability of a stock returns forecasting model to improve portfolio performance. The methodology maps a cross-section of fractile portfolios formed by rank-ordering on forecasted return into a related cross-section of control-matched fractile portfolios. No cross-sectional variation in controls such as beta, size, tax differences, and growth means no impact on the cross-section of realized returns.


Stock Return Systematic Risk Sharpe Ratio Dividend Yield Control Constraint 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.


Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.


  1. Adrian, T. and J. Rosenberg. 2008. “Stock Returns and Volatility: Pricing the Short-Run and Longrun Components of Market Risk.” Journal of Finance 63, 2997–3030.CrossRefGoogle Scholar
  2. Banz, R. 1981. “The Relationship Between Returns and Market Value of Common Stocks.” Journal of Financial Economics 9, 3–18.CrossRefGoogle Scholar
  3. Basu, S. 1974. The Relationship Between Investment Performance of Equity Securities and Their Price-Earnings Ratios: A Test of the Efficient Market-Expected Return Model. Unpublished Doctoral Dissertation, Cornell University.Google Scholar
  4. Basu, S. 1977. “Investment Performance of Common Stocks in Relations to Their Price Earnings Ratios: A Test of Market Efficiency.” Journal of Finance 32, 663–682.CrossRefGoogle Scholar
  5. Basu, S. 1983. “The Relationship Between Earnings Yield, Market Value and Return for NYSE Common Stocks: Further Evidence.” Journal of Financial Economics 12, 129–156.CrossRefGoogle Scholar
  6. Bernhard, A. 1959. The Evaluation of Common Stocks. New York: Simon and Schuster.Google Scholar
  7. Bloch, M., J.B.Guerard Jr., H.M. Markowitz, P. Todd, and G.L. Xu. 1993. “A Comparison of Some Aspects of the U.S. and Japanese Equity Markets.” Japan & the World Economy 5, 3–26.Google Scholar
  8. Blume, M. 1980. “Stock Return and Dividend Yield: Some More Evidence,” Review of Economics and Statistics 62, 567–577.CrossRefGoogle Scholar
  9. Blume, M.E., M.N. Gultekin, and N.B. Gultekin. 1990. “Validating Return-Generating Models.” Working Paper.Google Scholar
  10. Box, G.E.P. 1954. “The Exploration and Exploitation of Response Surfaces.” Biometrica 10, 16–60.CrossRefGoogle Scholar
  11. Box, G.E.P. and N.R. Draper. 1959. “A Basis for the Selection of a Response Surface Design.” Journal of the American Statistical Association 54, 622–654.CrossRefGoogle Scholar
  12. Box, G.E.P. and N.R. Draper. 1987. Empirical Model Building and Response Surfaces. New York: Wiley Interscience.Google Scholar
  13. Box, G.E.P. and N.R. Draper. 2007. Response Surfaces, Mixtures, and Ridge Analysis. New York: Wiley Interscience.CrossRefGoogle Scholar
  14. Box, G.E.P., J.S. Hunter, and W.G. Hunter. 2005. Statistics for Experimenters. New York: Wiley Interscience.Google Scholar
  15. Brennen, M. 1970. “Taxes, Market Valuation and Financial Policy.” National Tax Journal 23, 417–429.Google Scholar
  16. Brown, S.J. 1993. “Nonlinear Systems Estimation: Asset Pricing Model Applications.” In H. Varian (ed.), Economic and Financial Modeling with Mathematica. New York: Springer Verlag.Google Scholar
  17. Brown, S.J. 2008. “Elusive Return Predictability: Discussion.” International Journal of Forecasting 24, 19–21.CrossRefGoogle Scholar
  18. Brown, S.J. and M.I. Weinstein. 1983. “A New Approach to Testing Asset Pricing Models: The Bilinear Paradigm.” Journal of Finance 38, 711–743.CrossRefGoogle Scholar
  19. Campbell, J.Y., J. Hilscher, and H. Szilagyi. 2008. “In Search of Distress Risk.” Journal of Finance 63, 2899–2939.CrossRefGoogle Scholar
  20. Chan, L.K.C., N. Jegadeesh, and J. Lakonishok. 1996. “Momentum Strategies.” Journal of Finance 51, 1681–1713.CrossRefGoogle Scholar
  21. Conner, G., and R.A. Korajczak. 1988. “Risk and Return in an Equilibrium APT: Application of a New Test Methodology.” Journal of Financial Economics 21, 255–289.CrossRefGoogle Scholar
  22. Conner, G. and R.A. Korajczak. 1993. “A Test for the Number of Factors in an Approximate Factor Model.” Journal of Finance 48, 1263–1291.CrossRefGoogle Scholar
  23. Cooper, M.J., H. Gulen, and M.J. Schill. “Asset Growth and the Cross-Section of Stock Returns.” Journal of Finance 63, 1609–1651.Google Scholar
  24. Dhrymes, P.J., I. Friend, and N.B. Gülteikin. 1984. “A Critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory.” Journal of Finance 39, 323–346.CrossRefGoogle Scholar
  25. Dhrymes, P.J., I. Friend, M.N. Gültekin, and N.B. Gültekin. 1985a. “New Tests of the APT and Their Implications.” Journal of Finance 40, 659–674.CrossRefGoogle Scholar
  26. Dhrymes, P.J., I. Friend, N.B. Gültekin, and M.N. Gültekin. 1985b. “An Empirical Examination of the Implications of Arbitrage Pricing Theory.” Journal of Banking and Finance 9, 73–99.CrossRefGoogle Scholar
  27. Dremen, D. 1979. Contrarian Investment Strategy. New York: Random House.Google Scholar
  28. Dremen, D. 1998. Contrarian Investment Strategies: The Next Generation. New York: Simon and Schuster.Google Scholar
  29. Elton, E.J., M.J. Gruber, and M.W. Padberg. 1979. “Simple Criteria for Optimal Portfolio Selection: The Multi-Index Case.” In E.J. Elton and M.J. Gruber (eds.), Portfolio Theory, 25 Years After: Essays in Honor of Harry Markowitz. Amsterdam: North-Holland.Google Scholar
  30. Fama, E.F. and K.R. French. 1988. “Dividend Yields and Expected Stock Returns.” Journal of Financial Economics 22, 3–25.CrossRefGoogle Scholar
  31. Fama, E.F. and K.R. French. 1992. “Cross-Sectional Variation in Expected Stock Returns.” Journal of Finance 47, 427–465.CrossRefGoogle Scholar
  32. Fama, E.F. and K.R. French. 1995. “Size and the Book-to-Market Factors in Earnings and Returns. Journal of Finance 50, 131–155.CrossRefGoogle Scholar
  33. Fama, E.F. and K.R. French. 2008a. “Dissecting Anomalies.” Journal of Finance 63, 1653–1678.CrossRefGoogle Scholar
  34. Fama, E.F. and K.R. French. 2008b “Average Returns, B/M, and Share Issues,” Journal of Finance 63, 2971–2995.CrossRefGoogle Scholar
  35. Fama, E.F. and J. MacBeth. 1973. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy 81, 607–636.CrossRefGoogle Scholar
  36. Ferson, W.E. and C.R. Harvey. 1991a. “The Variation of Economic Risk Premiums.” Journal of Political Economy 99, 385–415.CrossRefGoogle Scholar
  37. Ferson, W.E. and C.R. Harvey. 1991b. “Sources of Predictability in Portfolio Returns.” Financial Analysts Journal 47, 49–56.CrossRefGoogle Scholar
  38. Ferson, W.E. and C.R. Harvey. 1995. “Explaining the Predictability of Asset Returns.” In A Chen (ed.), Research in Finance 11.Google Scholar
  39. Ferson, W.E. and C.R. Harvey. 1998. “Fundamental Determinants of National Equity Market Returns: A Perspective on Conditional Asset Pricing.” Journal of Banking & Finance 21, 1625–1665.CrossRefGoogle Scholar
  40. Graham, B. and D.L. Dodd. 1934. Security Analysis. New York: McGraw-Hill Book Company.Google Scholar
  41. Graham, B., D. Dodd, and S. Cottle. 1962. Security Analysis: Principles and Techniques, 4th edition. New York: McGraw-Hill Book Company.Google Scholar
  42. Guerard, J.B. Jr. and S. Chettiappan. 2009. “Stock Selection Modeling and Data Mining Corrections: Long-Only versus 130/30 Models.” This Volume.Google Scholar
  43. Guerard, J.B. Jr., M.G. Gultekin, and B.K. Stone. 1997. “The Role of Fundamental Data and Analysts’ Earnings Breadth, Forecasts, and Revisions in the Creation of Efficient Portfolios.” In A. Chen (ed.), Research in Finance 15, 69–91.Google Scholar
  44. Hamada, R.S. 1972. “The Effect of the Firm’s Capital Structure on the Systematic Risk of Common Stocks. Journal of Finance 27, 435–452.CrossRefGoogle Scholar
  45. Haugen R.A. 2001. Modern Investment Theory, 5th edition. Upper Saddle River, NJ: Prentice Hall.Google Scholar
  46. Haugen, R.A. 1999. The Inefficient Stock Market, 5th Edition. Upper Saddle River, NJ: Prentice Hall.Google Scholar
  47. Haugen, R.A. and N. Baker. 1996. “Communality in the Determinants of Expected Results.” Journal of Financial Economics 41, 401–440.CrossRefGoogle Scholar
  48. Jaffe, J., D.B. Keim, and R. Westerfield. 1989. “Earnings, Yields, Market Values, and Stock Returns.” Journal of Finance 44, 135–148.CrossRefGoogle Scholar
  49. Khuri, A.I., and J.A. Cornell. 1996. Response Surfaces: Designs and Analysis. New York: Marcel Dekker, Inc.Google Scholar
  50. Lakonishok, J., A. Shleifer, and R.W. Vishny. 1994. “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance 49, 1541–1578.CrossRefGoogle Scholar
  51. Latane, H.A., D.L. Tuttle, and C.P. Jones. 1975. Security Analysis and Portfolio Management, 2nd Edition. New York: The Roland Press.Google Scholar
  52. Lease, R.C., K. John, A. Kalay, U. Loewenstein, and O.H. Sarig. 2000. Dividend Policy: Its Impact on Firm Value. Boston: Harvard Business School Press.Google Scholar
  53. Levy, H. 1999. Introduction to Investments. Cincinnati: South-Western College Publishing. Second Edition.Google Scholar
  54. Markowitz, H.M. 1952. “Portfolio Selection.” Journal of Finance 7, 77–91.CrossRefGoogle Scholar
  55. Markowitz, H.M. 1959. Portfolio Selection: Efficient Diversification of Investment. Cowles Foundation Monograph No. 16. New York: Wiley.Google Scholar
  56. Markowitz, H.M. 1976. “Investment in the Long Run: New Evidence for an Old Rule.” Journal of Finance 31, 1273–1286.CrossRefGoogle Scholar
  57. Markowitz, H.M. 1984. “The Two-Beta Trap.” Journal of Portfolio Management 11, 12–19.Google Scholar
  58. Markowitz, H.M. 1987. Mean–Variance Analysis in Portfolio Choice and Capital Markets. Oxford: Basil Blackwell.Google Scholar
  59. Markowitz, H.M. 1991. “Foundations of Portfolio Theory.” Journal of Finance 46(2), 469–477.CrossRefGoogle Scholar
  60. Markowitz, H.M. 2000. Mean–Variance Analysis in Portfolio Choice and Capital Markets. New Hope, PA: Frank J. Fabozzi Associates.Google Scholar
  61. Markowitz, H.M., and G. Xu. 1994. “Data Mining Corrections.” Journal of Portfolio Management 21, 60–69.CrossRefGoogle Scholar
  62. Myers, R.H. 1976. Response Surface Methodology. Boston: Allyn & Bacon.Google Scholar
  63. Myers, R.H., A.I. Khuri, W.H. Corter Jr. 1989. “Response Surface Methodology: 1966–1988, Technometrics, 31, 137–157.CrossRefGoogle Scholar
  64. Peterson, P., D. Peterson, and J. Ang. 1985. “Direct Evidence on the Marginal Rate of Taxation on Dividend Income.” Journal of Financial Economics 14, 267–282.CrossRefGoogle Scholar
  65. Pilotte, E.A. 2003. “Capital Gains, Dividend Yields, and Expected Inflation.” Journal of Finance 58, 447–466.CrossRefGoogle Scholar
  66. Ramnath, S., S. Rock, and P. Shane. 2008. “The Financial Analyst Forecasting Literature: A Taxonomy with Suggestions for Further Research.” International Journal of Forecasting 24, 34–75.CrossRefGoogle Scholar
  67. Rosenberg, B. 1974. “Extra-Market Components of Covariance in Security Returns.” Journal of Financial and Quantitative Analysis 9, 263–274.CrossRefGoogle Scholar
  68. Rosenberg, B., and V. Marathe. 1979. “Tests of Capital Asset Pricing Hypotheses.” In H. Levy (ed.), Research in Finance 1.Google Scholar
  69. Rudd, A., and B. Rosenberg. 1979. “Realistic Portfolio Optimization.” In E. Elton and M. Gruber (eds.), Portfolio Theory, 25 Years After. Amsterdam: North-Holland Publishing Co.Google Scholar
  70. Rudd, A., and B. Rosenberg. 1980. “The ‘Market Model’ in Investment Management.” Journal of Finance 35, 597–607.CrossRefGoogle Scholar
  71. Rosenberg, B., and A. Rudd. 1977. “The Yield/Beta/Residual Risk Tradeoff.” Working paper 66. Research Program in Finance, Institute of Business and Economic Research, University of California, Berkeley.Google Scholar
  72. Rosenberg, B., and A. Rudd. 1982. “Factor-Related and Specific Returns of Common Stocks: Serial Correlation and Market Inefficiency.” Journal of Finance 37, 543–554.CrossRefGoogle Scholar
  73. Sharpe, W.F. 1963. “A Simplified Model for Portfolio Analysis.” Management Science 9, 277–293.CrossRefGoogle Scholar
  74. Sharpe, W.F. 1964. “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” Journal of Finance 19, 425–442.CrossRefGoogle Scholar
  75. Sharpe, W.F. 1967. “A Linear Programming Algorithm for Mutual Fund Portfolio Selection.” Management Science 13, 449–510.CrossRefGoogle Scholar
  76. Sharpe, W.F. 1971. “A Linear Programming Approximation for the General Portfolio Problem.” Journal of Financial and Quantitative Analysis 6, 1263–1275.CrossRefGoogle Scholar
  77. Stone, B.K. 1973. “A Linear Programming Formulation of the General Portfolio Selection Problem.” Journal of Financial and Quantitative Analysis 8, 621–636.CrossRefGoogle Scholar
  78. Stone, B.K. 2003. “Rank-Based Security Grouping, Multicolinearity, and the Assessment of Cross-Sectional Return Dependencies,” Working Paper. The Marriott School of Management, Brigham Young University.Google Scholar
  79. Stone, B.K., D.L. Adolphson, and T.W. Miller. 1993. “Optimal Data Selection and Grouping: An Extension of Traditional Response Surface Methodology to Observational Studies Involving Noncontrolled Empirical Data Generation.” Advances in Mathematical Programming and Financial Planning. 3, 39–68.Google Scholar
  80. Stowe, J.D., T.R. Robinson, J.E. Pinto, D.W. McLeavey. 2002. Analysis of Equity Investments: Valuation. Charlottesville, VA: Association for Investment Management and Research.Google Scholar
  81. Stowe, J.D., T.R. Robinson, J.E. Pinto, D.W. McLeavey. 2007. Equity Asset Valuation. Hoboken NJ: John Wiley & Sons for CFA Institute and Association for Investment Management and Research.Google Scholar
  82. Timmerman, A. 2008a. “Elusive Return Predictability.” International Journal of Forecasting 24, 1–18.CrossRefGoogle Scholar
  83. Timmerman, A. 2008b. “Reply to Discussion of Elusive Return Predictability.” International Journal of Forecasting 24, 29–30.CrossRefGoogle Scholar
  84. Williams, J.B. 1938. The Theory of Investment Value. Cambridge: HarvardUniversity Press.Google Scholar
  85. Ziemba, W.T. 1991 “Fundamental Factors in US and Japanese Stock Returns.” Berkeley Program in Finance.Google Scholar

Copyright information

© Springer Science+Business Media, LLC 2010

Authors and Affiliations

  1. 1.Marriott SchoolBrigham Young UniversityUtahProvo
  2. 2.McKinley Capital Management, LLCAnchorageUSA

Personalised recommendations