Neural network techniques for financial performance prediction: integrating fundamental and technical analysis

This research project investigates the ability of neural networks, specifically, the backpropagation algorithm, to integrate fundamental and technical analysis for financial performance prediction. The predictor attributes include 16 financial statement variables and 11 macroeconomic variables. The rate of return on common shareholders' equity is used as the to-be-predicted variable. Financial data of 364 S&P companies are extracted from the CompuStat database, and macroeconomic variables are extracted from the Citibase database for the study period of 1985-1995. Used as predictors in Experiments 1, 2, and 3 are the 1 year's, the 2 years', and the 3 years' financial data, respectively. Experiment 4 has 3 years' financial data and macroeconomic data as predictors. Moreover, in order to compensate for data noise and parameter misspecification as well as to reveal prediction logic and procedure, we apply a rule extraction technique to convert the connection weights from trained neural networks to symbolic classification rules. The performance of neural networks is compared with the average return from the top one-third returns in the market (maximum benchmark) that approximates the return from perfect information as well as with the overall market average return (minimum benchmark) that approximates the return from highly diversified portfolios. Paired t tests are carried out to calculate the statistical significance of mean differences. Experimental results indicate that neural networks using I year's or multiple years' financial data consistently and significantly outperform the minimum benchmark, but not the maximum benchmark. As for neural networks with both financial and macroeconomic predictors, they do not outperform the minimum or maximum benchmark in this study. The experimental results also show that the average return of 0.25398 from extracted rules is the only compatible result to the maximum benchmark of 0.2786. Consequentially, we demonstrate rule extraction as a postprocessing technique for improving prediction accuracy and for explaining the prediction logic to financial decision makers. (C) 2003 Elsevier B.V. All rights reserved.