A New Quantitative Predictability-Based Method of Risk Measurement to Make Profitable Investment Decisions in Financial Markets

Abstract

The ultimate goal of investment in financial markets is to achieve the maximum expected rate of return. Risk is one of the most important factors in making profitable investment decisions. Therefore, in the literature, many efforts have been made to define, model, and determine the effect of it in making financial decisions. The first and the most fundamental attempt to quantitatively model the risk and involve it in making investment decisions is related to Markowitz’s studies. The results of these studies, besides many financial applications, have been the basis for other riskbased studies. Such methods have been investors’ main instrument in developing profitable investment strategies. However, despite scientific and practical advantages, none of them consider the predictability of under-study systems. While the predictability logically has a non-strict inverse relationship with the risk. In this paper, a new method for measuring risk based on the predictability is presented to eliminate this disadvantage. In the proposed method, Markowitz methods have been developed by entering predictability. Accordingly, the proposed method, besides the advantages of Markowitz methods, enters predictability in risk measurement. In order to evaluate the performance of the proposed method in risk measurement and investment decisions, in comparison to other methods, data from twenty companies listed on the Tehran Stock Exchange were used. The empirical results indicate the efficiency of the proposed method to make financial decisions in comparison with other methods.