Topic 11

Chapter 15
Time-series Forecasting
PowerPoint to accompany:
Learning Objectives
After studying this Chapter you should have a better understanding of:

The importance of business forecasting. The components of a time series. How and when to use moving averages. How to use linear trend, quadratic trend and exponential trend time-series models. How to choose the most appropriate time-series forecasting model. How to develop a forecasting model for seasonal data.
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442549272/Berenson/Business Statistics /2e
Importance of Forecasting
Governments forecast unemployment, interest rates and expected revenues from income taxes for policy purposes. Marketing executives forecast demand, sales and consumer preferences for strategic planning. University administrators forecast enrolments to plan for facilities and for faculty recruitment.
Retail stores forecast demand to control inventory levels, hire employees and provide training.
Common Approaches to Forecasting

Common Approaches to Forecasting
Qualitative forecasting methods Used when historical data are unavailable Considered highly subjective and judgmental
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Quantitative forecasting methods
Time Series Use past data to predict future values
Causal
Time-series Data and Plot

Numerical data obtained at regular time intervals. The time intervals can be annually, quarterly, daily, hourly etc. A time-series plot is a two-dimensional plot of time series data. The vertical axis measures the variable of interest.
Australia's Unemployment Rate
Unemployment rate (%) 12.0 10.0 8.0 6.0 4.0
The horizontal axis corresponds to the time periods.

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2.0
0.0 197980
198586
199192
Year
199798
200304
Classical Multiplicative Time-series Model Components

Time Series
Trend component Overall, persistent long-term upward or downward movement Seasonal component Regular periodic fluctuation, usually within a 12month period Cyclical component Repeating swings or movements over more than one year Irregular component
Erratic or residual fluctuations
Trend Component
Long-run increase or decrease over time (overall upward or downward movement). Data taken over a long period of time. Trend can be upward or downward. Trend can be linear or non-linear. Sales Sales
Time Downward linear trend

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Time Upward non-linear trend
Seasonal Component
Short-term regular wave-like patterns. Observed within 1 year. Often monthly or quarterly. Sales Winter Summer Winter Spring Spring Autumn Summer
Autumn
Time (Quarterly)
Cyclical Component
Long-term wave-like patterns. Usually occur every 2-10 years. Often measured peak to peak or trough to trough.
1 Cycle Sales
Year
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Irregular Component
Unpredictable, random, residual fluctuations. Due to random variations of:

Nature. Accidents or unusual events.
Noise in the time series.
Usually short duration and non-repeating.
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Multiplicative Time-series Model for Annual Data

Used primarily for forecasting.
Observed value in time series is the product of components.
Yi Ti Ci I i
Where Ti = value of trend component Ci = value of cyclical component Ii = value of irregular (random) component
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Multiplicative Time-series Model with Seasonal Component

Used primarily for forecasting. Allows consideration of seasonal variation.
Yi Ti Si Ci Ii
Where Ti = value of trend component Si = value of seasonal component Ci = value of cyclical component Ii = value of irregular (random) component
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Smoothing the Annual Time Series Moving Averages

A series of arithmetic means over time. Calculate moving averages to get an overall impression of the pattern of movement over time. Moving averages can be used for smoothing: averages of consecutive time-series values for a chosen period of length (L). Result dependent upon choice of L (length of period for computing means). Examples:

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For a 5 year moving average, L = 5. For a 7 year moving average, L = 7 etc.

Moving Averages
Example: Five-year moving average (L=5) First average:
Y1 Y2 Y3 Y4 Y5 MA(5) 5
Second average:
Y2 Y3 Y4 Y5 Y6 MA(5) 5
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Example: Annual Data

Year 1 2 3 4 5 6 7 8 9 10 11 etc.
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Sales 23 40 25 27 32 48 33 37 37 50 40 etc.
Annual Sales
60 50 40
Sales
30 20 10 0 1 2 3 4 5 6 Year 7 8 9 10 11
Calculating Moving Averages

Year 1 2 3 4 5 6 Sales 23 40 25 27 32 48
Average Year
3 4
5-Year Moving Average 29.4 34.4
5
6 7 8
33.0
35.4 37.4 41.0
7
8 9 10 11
33
37 37 50 40
39.4
Each moving average is for a consecutive block of 5 years e.g. 23 40 25 27 32 29.4 5
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Annual vs. Moving Average

Annual vs. 5Year Moving Average
60 50 40
Sales
30 20 10 0 1 2 3 4 5 6 Year
Annual 5-Year Moving Average
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The 5-year moving average smoothes the data and shows the underlying trend.
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Least-squares Trend-fitting
Estimate a trend line using regression analysis. Time Period (X) 0 1 2 3 4 5 Use time (X) as the independent variable.
Year 1999 2000 2001 2002 2003 2004
Sales (Y)
20 40 30 50 70 65
b b X Y 0 1 i 21.905 9.5714 X i Y
Sales trend
80 70 60 50 40 30 20 10 0 0 1 2 3 4 5 6
sales
Year
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Non-linear Trend Forecasting

A non-linear regression model can be used when the time series exhibits a non-linear trend.
Quadratic form is one type of a non-linear model.
Yi 0 1X i 2 X i
2 i
Compare adj. r2 and standard error to that of linear model to see if this is an improvement. Can try other functional forms to get best fit.
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Exponential Trend Model

Another non-linear trend model:
Yi
Xi 0 1
Transform to linear form using base-10 logs (alternatively use base e).
log(Y i ) log( 0 ) Xi log( 1 ) log( i )
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Exponential Trend Model

Exponential trend forecasting equation:
) b b X log(Y i 0 1 i
Where b0 = estimate of log(0) b1 = estimate of log(1)
Interpretation:
1) 100 % ( 1
is the estimated annual compound growth rate in %
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Model Selection
Use a linear trend model if the first differences are approximately constant.
(Y2 Y1 ) ( Y3 Y2 ) ( Yn Yn-1 )
Use a quadratic trend model if the second differences are approximately constant.
[(Y3 Y2 ) ( Y2 Y1 )] [(Y4 Y3 ) ( Y3 Y2 )] [(Yn Yn-1 ) ( Yn-1 Yn-2 )]

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Model Selection
Use an exponential trend model if the percentage differences are approximately constant.
(Y3 Y2 ) (Y2 Y1 ) (Yn Yn-1 ) 100 % 100 % 100 % Y1 Y2 Yn-1
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Choosing a Forecasting Model

Perform a residual analysis:
look for pattern or direction.
Measure magnitude of residual error:

using squared differences. using absolute differences.
Use simplest model:
principle of parsimony.
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Residual Analysis
e
e 0
Random errors
T
Cyclical effects not accounted for
e 0
T
Trend not accounted for
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T
Seasonal effects not accounted for
Measuring Errors
Choose the model that gives the smallest measuring errors.
Sum of squared errors (SSE)
Mean Absolute Deviation (MAD)
)2 SSE (Yi Y i
i 1
MAD
Y Y
i 1 i
Sensitive to outliers
Not sensitive to extreme observations
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The Principle of Parsimony

Suppose two or more models provide a good fit for the data. Select the simplest model. Simplest model types:

Least-squares linear Least-squares quadratic 1st order autoregressive. 2nd and pth order autoregressive Least-squares exponential
More complex types:

Holt-Winters.
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Forecasting with Seasonal Data

Recall the classical time-series model with seasonal variation.
Yi Ti Si Ci Ii
If the seasonality is quarterly, define three new dummy variables for quarters. Q1 = 1 if first quarter, 0 otherwise
Q2 = 1 if second quarter, 0 otherwise

Q3 = 1 if third quarter, 0 otherwise (Quarter 4 is the default if Q1 = Q2 = Q3 = 0)
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Exponential Model with Quarterly Data
Yi 0 2 3 4 i
Xi 1 Q1 Q2 Q3
(11)x100% is the quarterly compound growth rate in % i provides the multiplier for the ith quarter relative to the 4th quarter (i = 2, 3, 4) Transform to linear form:
log(Y i ) log(0 ) Xilog(1 ) Q1log( 2 ) Q2log(3 ) Q3log( 4 ) log( i )

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Estimating the Quarterly Model

Exponential forecasting equation:
) b b X b Q b Q b Q log(Y i 0 1 i 2 1 3 2 4 3
Where
b0 = estimate of log(0), so 10b0 0 b1 = estimate of log(1), so 10 b1 1 etc.
Interpretation:
1) 100 % = estimated quarterly compound growth rate (in %) ( 1
= estimated multiplier for first quarter relative to fourth quarter 2 = estimated multiplier for second quarter relative to fourth quarter 3 = estimated multiplier for third quarter relative to fourth quarter 4
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Quarterly Model Example

Suppose the forecasting equation is:
) 3.43 .017X .082Q .073Q .022Q log(Y i i 1 2 3

b0 = 3.43, so
b1 = .017,
so
b2 = -.082, so b3 = -.073, so b4 = .022, so
0.827 10b 2 b 0.845 10 3 b 1.052 10 4

2
3
2691.53 10b0 0 1.040 10 b1 1
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Quarterly Model Example Value: Interpretation:

2691.53 Unadjusted trend value for first quarter of first year 0
1.040 1
0.827 2
4.0% = estimated quarterly compound growth rate Average sales in Q2 are 82.7% of average 4th quarter sales, adjusting for the 4% quarterly growth rate
0.845 3
Average sales in Q3 are 84.5% of average 4th quarter

sales, adjusting for the 4% quarterly growth rate
1.052 4
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Average sales in Q4 are 105.2% of average 4th quarter
sales, adjusting for the 4% quarterly growth rate

Pitfalls in Time-series Analysis

Assuming the mechanism that governs the time-series behaviour in the past will still hold in the future. Using mechanical extrapolation of the trend to forecast the future without considering personal judgements, business experiences, changing technologies, and changing habits.
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Industry Application Leading Economic Indicator Forecasts No Downturn In 2012.

The Conference Board Leading Economic Index (LEI) uses both index numbers and forecasting techniques to help predict business cycle conditions in the US.
Source: http://econintersect.com/wordpress/?p=23308
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Chapter Summary
Discussed the importance of forecasting. Addressed component factors of the classical multiplicative time-series model: Trend, Seasonal, Cyclical and Irregular. Performed smoothing of data series: Moving averages Described least-square trend fitting and forecasting: Linear, quadratic and exponential models.
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Chapter Summary
Described procedure for choosing appropriate models: Residual analysis, measuring magnitude of residual error, principle of parsimony. Addressed time-series forecasting of seasonal data (monthly or quarterly data) using dummy variables.
Discussed pitfalls concerning time-series analysis.
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Chapter 15

Common Approaches to Forecasting

Quantitative forecasting methods

Time Series Use past data to predict future values

Time-series Data and Plot

The horizontal axis corresponds to the time periods.

Classical Multiplicative Time-series Model Components

Erratic or residual fluctuations

Time Downward linear trend

Time Upward non-linear trend

Nature. Accidents or unusual events.

Noise in the time series.

Usually short duration and non-repeating.

Multiplicative Time-series Model for Annual Data

Multiplicative Time-series Model with Seasonal Component

Smoothing the Annual Time Series Moving Averages

For a 5 year moving average, L = 5. For a 7 year moving average, L = 7 etc.

Example: Annual Data

Calculating Moving Averages

5-Year Moving Average 29.4 34.4

Each moving average is for a consecutive block of 5 years e.g. 23 40 25 27 32 29.4 5

Annual vs. Moving Average

Year 1999 2000 2001 2002 2003 2004

Non-linear Trend Forecasting

Quadratic form is one type of a non-linear model.

Exponential Trend Model

log(Y i ) log( 0 ) Xi log( 1 ) log( i )

Exponential Trend Model

Where b0 = estimate of log(0) b1 = estimate of log(1)

is the estimated annual compound growth rate in %

[(Y3 Y2 ) ( Y2 Y1 )] [(Y4 Y3 ) ( Y3 Y2 )] [(Yn Yn-1 ) ( Yn-1 Yn-2 )]

(Y3 Y2 ) (Y2 Y1 ) (Yn Yn-1 ) 100 % 100 % 100 % Y1 Y2 Yn-1

Choosing a Forecasting Model

look for pattern or direction.

Measure magnitude of residual error:

using squared differences. using absolute differences.

Use simplest model:

Sum of squared errors (SSE)

Mean Absolute Deviation (MAD)

Not sensitive to extreme observations

The Principle of Parsimony

More complex types:

Forecasting with Seasonal Data

Q2 = 1 if second quarter, 0 otherwise

Exponential Model with Quarterly Data

log(Y i ) log(0 ) Xilog(1 ) Q1log( 2 ) Q2log(3 ) Q3log( 4 ) log( i )

Estimating the Quarterly Model

b0 = estimate of log(0), so 10b0 0 b1 = estimate of log(1), so 10 b1 1 etc.

Quarterly Model Example

) 3.43 .017X .082Q .073Q .022Q log(Y i i 1 2 3

b2 = -.082, so b3 = -.073, so b4 = .022, so

0.827 10b 2 b 0.845 10 3 b 1.052 10 4

2691.53 10b0 0 1.040 10 b1 1

Quarterly Model Example Value: Interpretation:

Average sales in Q3 are 84.5% of average 4th quarter

Average sales in Q4 are 105.2% of average 4th quarter

sales, adjusting for the 4% quarterly growth rate

Pitfalls in Time-series Analysis

Industry Application Leading Economic Indicator Forecasts No Downturn In 2012.

Discussed pitfalls concerning time-series analysis.

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