(Mis)Understanding Benign Overfitting in Equity Return Prediction
Authors: Hui Guo, Jiawei Huang, Runze Li, Yan Yu
Organizations: Carl H. Lindner College of Business, University of Cincinnati · Católica Lisbon School of Business and Economics, Universidade Católica Portuguesa · Department of Statistics, Pennsylvania State University
Highly overparameterized models often predict well despite interpolating training data in complex domains, challenging the classical bias--variance tradeoff. We investigate whether this ``benign overfitting'' phenomenon extends to equity return prediction. Consistent with recent statistical theory, we document two key phenomena: first, a double descent pattern in the ridgeless model's prediction risk; and second, that while the optimal ridge model consistently outperforms its ridgeless counterpart, this performance gap becomes negligible at large parameter-to-observation ratios. Ultimately, however, both models fail to outperform a simple historical average. This empirical evidence aligns with our asymptotic results under the null hypothesis of zero slope coefficients, suggesting that standard equity predictors lack true forecasting power---even within highly flexible, nonlinear machine learning architectures. These findings reconcile modern and classical machine learning in asset pricing: in the absence of a true signal, they asymptotically collapse to the historical average benchmark.
Figures & tables
Figure 1: Out-of-sample test risk (mean squared error) against γ=P/T . Each color corresponds to a different training window length ( T=12 , 60 , and 120 months). Solid lines show the ridgeless estimator ( z→0+ ); dashed lines show the heavily regularized benchmark ( z=109 ), which virtually overlay their historical averages respectively. The vertical dashed line at γ=1 marks the interpolation threshold.
Portfolio
k
OOS R2
SR
Corr
tα1
tα2
(z=10k)
Panel A: 1931–1974
1
Market
0.46
2
History
0.52
3.00
3
RFF
9
0.00
0.52
1.00
3.00
1.05
4
Linear
9
0.00
0.52
1.00
3.00
-0.24
Table 1: Market-Timing Performance: 12-Month Training Windows
Figure 2: Newey–West t -Statistic of α2 for the RFF Model across regularization values: 12-Month Training Windows
Portfolio
SR
Corr
tα1
tα2
Panel A: 1931–1974
1
History
0.52
2.99
2
TsMom
0.54
0.95
2.93
-0.21
3
VolMom
0.52
0.64
2.49
0.64
4
DW
0.55
0.93
3.38
1.65
5
PV
0.54
0.41
2.32
0.96
Table 2: Historical Average Benchmark and Momentum Strategies: 12-Month Training Windows
SR
OOS R2
tα1
tα2
Original Data
0.43
− 0.01
2.82
0.67
Percentile
33.00
0.00
8.00
3.00
Mean
0.43
0.00
2.88
1.33
Median
0.43
0.00
2.88
1.36
Std
0.01
0.00
0.05
0.36
5th Pct
0.42
0.00
2.81
0.77
Table 3: Bootstrap Null Distribution of Out-of-Sample Performance: 12-Month Window
Non-centered Predictors (KMZ)
Centered Predictors
Portfolio
k
SR
Corr
tα1
tα2
SR
Corr
tα1
tα2
(z=10k)
Panel A: 1931–1974
1
Market
0.46
0.46
2
History
0.52
3.00
0.52
3.00
3
RFF
9
0.27
0.37
0.78
-0.18
0.18
0.04
1.13
1.02
Table 4: Market-Timing Performance: 12-Month Training Windows with KMZ No Intercept with Non-centered Market Return
Appendix figures & tables10 assets
Supplementary material from the paper’s appendix.
Appendix
Figure A1: Newey–West t -Statistic of α2 for the RFF Model across regularization values: 60-Month Training Windows
Figure A2: Newey–West t -Statistic of α2 for the RFF Model across regularization values: 120-Month Training Windows
Portfolio
k
OOS R2
SR
Corr
tα1
tα2
(z=10k)
Panel A: 1935–1974
1
Market
0.52
2
History
0.58
1.44
3
RFF
9
0.00
0.58
1.00
1.44
0.73
4
Linear
9
0.00
0.58
1.00
1.44
1.88
Appendix
Table A1: Market-Timing Performance: 60-Month Training Windows
Portfolio
k
OOS R2
SR
Corr
tα1
tα2
(z=10k)
Panel A: 1940–1974
1
Market
0.53
2
History
0.70
2.12
3
RFF
9
0.00
0.70
1.00
2.12
0.53
4
Linear
9
0.00
0.70
1.00
2.12
1.94
Appendix
Table A2: Market-Timing Performance: 120-Month Training Windows
Portfolio
SR
Corr
tα1
tα2
Panel A: 1935–1974
1
History
0.58
1.48
2
TsMom
0.57
1.00
1.38
-1.44
3
VolMom
0.50
0.89
1.21
-0.22
4
DW
0.55
0.94
1.54
0.25
5
PV
0.49
0.77
0.37
-0.25
Appendix
Table A3: Historical Average Benchmark and Momentum Strategies: 60-Month Training Windows
Portfolio
SR
Corr
tα1
tα2
Panel A: 1940–1974
1
History
0.70
2.15
2
TsMom
0.69
1.00
2.08
-1.25
3
VolMom
0.60
0.95
1.37
-1.28
4
DW
0.66
0.97
1.83
-0.50
5
PV
0.45
0.83
-0.60
-1.17
Appendix
Table A4: Historical Average Benchmark and Momentum Strategies: 120-Month Training Windows
SR
OOS R2
tα1
tα2
Original Data
0.46
− 0.00
1.54
1.41
Percentile
19.00
16.00
87.00
0.00
Mean
0.47
0.00
1.44
2.13
Median
0.47
− 0.00
1.44
2.15
Std
0.01
0.00
0.09
0.26
5th Pct
0.45
− 0.00
1.29
1.70
Appendix
Table A5: Bootstrap Null Distribution of Out-of-Sample Performance: 60-Month Window
SR
OOS R2
tα1
tα2
Original Data
0.56
0.00
2.46
1.90
Percentile
40.00
100.00
100.00
74.00
Mean
0.56
− 0.00
2.04
1.72
Median
0.56
− 0.00
2.03
1.67
Std
0.01
0.00
0.11
0.27
5th Pct
0.55
− 0.00
1.89
1.35
Appendix
Table A6: Bootstrap Null Distribution of Out-of-Sample Performance: 120-Month Window
k
Non-centered Predictors (KMZ)
Centered Predictors
Portfolio
(z=10k)
SR
Corr
tα1
tα2
SR
Corr
tα1
tα2
Panel A: 1935–1974
1
Market
0.52
0.52
2
History
0.58
1.44
0.58
1.44
3
RFF
9
0.36
0.40
1.04
0.70
0.09
-0.04
0.83
0.71
4
Linear
9
0.39
0.82
0.30
-0.92
0.25
-0.03
2.02
1.86
Appendix
Table A7: Market-Timing Performance: 60-Month Training Windows with KMZ No Intercept with Non-centered Market Return
k
Non-centered Predictors (KMZ)
Centered Predictors
Portfolio
(z=10k)
SR
Corr
tα1
tα2
SR
Corr
tα1
tα2
Panel A: 1940–1974
1
Market
0.53
0.53
2
History
0.70
2.12
0.70
2.12
3
RFF
9
0.38
0.40
1.06
0.63
0.08
-0.05
1.09
0.51
4
Linear
9
0.53
0.86
0.74
-0.56
0.21
-0.19
2.56
1.93
Appendix
Table A8: Market-Timing Performance: 120-Month Training Windows with KMZ No Intercept with Non-centered Market Return
The last decade of progress in machine learning (ML), especially the deep learning era, has raised a number of scientific questions that challenge the longstanding dogma of the field. One of the most important riddles was the good empirical generalization of overparameterized models. Overparameterized models are highly complex with respect to the size of the training dataset, which enables them to perfectly fit (i.e., interpolate) even noisy training data. Such interpolation of noisy data is traditionally associated with detrimental overfitting, and yet a wide range of interpolating models -- from simple linear models to deep neural networks -- have been observed to generalize remarkably well on fresh test data. Indeed, the discovery of the double descent phenomenon has revealed that highly overparameterized models can improve over the best underparameterized model in test performance. Understanding learning in this overparameterized regime required new theory and foundational empirical studies, even for the simplest case of the linear model. The underpinnings of this understanding have been laid in foundational analyses of overparameterized linear regression and related statistical learning tasks, mostly published between 2018 and 2022, which resulted in precise analytic characterizations of double descent. This paper provides an overview of the theory of overparameterized ML (henceforth abbreviated as TOPML) by focusing on explaining the most foundational findings through a statistical signal processing perspective. We emphasize the unique aspects that define the TOPML research area as a subfield of modern ML theory and outline interesting open frontiers that remain.
Yehuda Dar, Vidya Muthukumar, Richard G. Baraniuk
Faculty of Computer and Information Science, Ben-Gurion University · Schools of Electrical and Computer Engineering, and Industrial and Systems Engineering, Georgia Institute of Technology · Electrical and Computer Engineering Department, Rice University
Accurate prediction of equity returns remains a major challenge in computational finance due to the non-stationary, nonlinear, and low signal-to-noise ratio nature of financial time series. This paper proposes a hybrid two-stage architecture that combines a long short-term memory (LSTM) network with an XGBoost gradient-boosted regressor for multi-horizon stock return prediction across a diversified panel of 14 U.S. equities spanning six industry sectors. The LSTM component, comprising two stacked layers with 64 hidden units, processes 60-day sliding windows of five sequential market features to produce 64-dimensional temporal embeddings that encode learned sequential market dynamics. These embeddings are concatenated with 14 hand-crafted technical indicators to form a 78-dimensional hybrid feature vector, which is subsequently passed to an XGBoost regressor tuned via 3-fold cross-validation grid search. The framework is trained on a multi-stock pooled corpus using strict chronological splits and per-stock MinMaxScaling to prevent look-ahead bias, and evaluated across four prediction horizons of 30, 90, 252, and 365 trading days. Experimental results demonstrate that the hybrid model achieves a test RMSE of 0.0949 on the 30-day horizon, roughly one-third that of the standalone LSTM baseline, while marginally matching or surpassing the XGBoost-Only baseline across the majority of stocks. Directional accuracy rises with horizon length, reaching 97.6% at 365 days; we show, however, that this largely tracks the high base rate of positive long-horizon returns in the sample, and we therefore benchmark directional accuracy against a naive always-positive predictor and treat the above-base-rate gap at short horizons as the more informative signal. A composite investment scoring framework derived from multi-horizon predictions is further proposed to support portfolio ranking and decision support.
This paper investigates the asymptotic behavior of the out-of-sample prediction risk of the high-dimensional ridgeless least-squares estimator when the feature dimension p and the sample size n grow proportionally. We consider a generalized spiked population covariance model with multiple latent factors, where the number of spiked eigenvalues may remain finite or increase with n, and the spiked eigenvalues may be bounded or diverge at arbitrary rates. Beyond characterizing the impact of covariance spectra, we reveal a new mechanism underlying benign overfitting: the prediction behavior of ridgeless interpolation is fundamentally governed by the alignment between the regression coefficient β and the spiked eigenspaces of the population covariance matrix. In particular, we show that the signal energy distributed along latent spike directions determines whether interpolation leads to benign, tempered, or catastrophic overfitting. Our theoretical framework establishes sharp prediction risk limits under minimal moment conditions, requiring only finite fourth moments rather than Gaussianity. We characterize how the number, strength, and geometric structure of the spikes jointly influence the double-descent phenomenon. These results provide a unified understanding of when latent covariance structures facilitate or hinder generalization in overparameterized regression.
Zhijun Liu, Dandan Jiang
College of Sciences, Northeastern University, China. · School of Mathematics and Statistics, Xi’an Jiao Tong University, China.