Return Predictability, Model Uncertainty, and Robust Investment

Stock return predictability is subject to great uncertainty. In this paper we use the model confidence set approach to quantify uncertainty about expected utility from investment, accounting for potential return predictability. For monthly US data and six representative return prediction models, we find that confidence sets are very wide, change significantly with the predictor variables, and frequently include expected utilities for which the investor prefers not to invest. The latter motivates a robust investment strategy maximizing the minimal element of the confidence set. The robust investor allocates a much lower share of wealth to stocks compared to a standard investor.