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Correlated Errors: Why a Monotone Relationship Between Forecast Precision and Trading Profitability May Not Hold

Authors

  • Jochen Lawrenz,

  • Alex Weissensteiner

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    • The authors are respectively from the Department of Banking & Finance, Innsbruck University, Austria; and the School of Economics & Management, Free University of Bolzano, Italy. They thank Sandy Klasa, Marco LiCalzi, Klaus Schredelseker, Devin Shanthikumar, Martin Walker (editor) and an anonymous referee. This paper has also benefited from seminar participants at University Ca’ Foscari, Venice, AAA Annual Meeting 2009, New York and the Annual Meeting of the German Finance Association 2009, Frankfurt.


Alex Weissensteiner, Free University of Bozen, 39400 Bolzano, Italy. e-mail: alex.weissensteiner@unibz.it

Abstract

Abstract:  This paper argues that the relation between financial analysts’ earnings forecast accuracy and their recommendation profitability has to be augmented by the extent of commonality in their forecast errors. We show that while accuracy is positively related to expected performance, the correlation in forecasting errors has a negative impact. This implies that a monotonic relationship between ex ante identifiable forecast accuracy and ex post recommendation profitability does not need to hold. Thus, agents may be better off by making comparatively large but less correlated errors, than by making precise but highly correlated forecasts.

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