On The Difficulty Of Measuring Forecasting Skill In Financial Markets

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The use of correlation between forecasts and actual returns is commonplace in the literature, often used as a measurement of investors' skill. A prominent application of this is the concept of the Information Coefficient (IC). Not only can IC be used as a tool to rate analysts and fund managers but it also represents an important parameter in the asset allocation and portfolio construction process. Nevertheless, theoretical understanding of it has typically been limited to the partial equilibrium context where the investing activities of each agent have no effect on other market participants. In this paper the authors show that this can be an undesirable oversimplification and they demonstrate plausible circumstances in which conventional empirical measurements of IC can be highly misleading.