Model uncertainty in financial forecasting

Abstract

Models necessarily capture only parts of a reality. Prediction models aim at capturing a future reality. In this paper we address the question of how the future is constructed (or: imagined) in an investment context where market participants form expectations on the returns of a risky investment. We observe that the participants' model choices are subject to unforeseeable change. The objective of the paper is to demonstrate that the resulting uncertainty may be reduced by incorporating relations among competing models in the estimation process.