Discussion paper

DP17194 The Virtue of Complexity in Return Prediction

We theoretically characterize the behavior of return prediction models in the high complexity regime, i.e. when the number of parameters exceeds the number of observations. Contrary to conventional wisdom in finance, return prediction R2 and optimal portfolio Sharpe ratio generally increase with model parameterization, even when minimal regularization is used. Empirically, we document this "virtue of complexity" in US equity market prediction. High complexity models deliver economically large and statistically significant out-of-sample portfolio gains relative to simpler models, due in large part to their remarkable ability to predict recessions.

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Citation

Malamud, S, B Kelly and K Zhou (eds) (2022), “DP17194 The Virtue of Complexity in Return Prediction”, CEPR Press Discussion Paper No. 17194. https://cepr.org/publications/dp17194