FORECASTING

PREDICTIVE ACCURACY OF FORECASTING

METHODS

• The forecast error at time t denoted by 𝑒𝑡 is defined as the

difference between the actual value 𝑦𝑡 and the forecast
value at time t:
𝑒𝑡 = 𝑦𝑡 − 𝐹𝑡
• The accuracy of a forecasting method is determined by
analysing the forecast errors.
PREDICTIVE ACCURACY OF FORECASTING
METHODS
• A few popular measures of predictive accuracy are:
1 𝑛
• MAE or MAD (mean absolute error/deviation)= σ𝑖=1 |𝑒𝑡 |. This
𝑛
gives the magnitude of the average absolute error.
1 𝑛
• AVERAGE ERROR= σ𝑖=1 𝑒𝑡 . This measure is similar to
𝑛
MAD except that it retains the sign of the errors, so that
negative errors cancel out positive errors of the same
magnitude. It, therefore, gives an indication of whether the
forecasts are on an average over or under predicting.
PREDICTIVE ACCURACY OF FORECASTING
METHODS
1 𝑛 𝑒𝑡
• MAPE = σ𝑖=1 | | × 100. This measure gives a
𝑛 𝑦𝑡
percentage score of how forecasts deviate from the actual
values. It is useful for comparing performance across series
of data that have different scales.
1 𝑛
• MSE = σ𝑖=1 𝑒𝑡 2 or
𝑛
1 𝑛
• RMSE = σ𝑖=1 𝑒𝑡 2 . This measure has the same units as
𝑛
the data series.
EXPONENTIAL SMOOTHING METHODS
SIMPLE EXPONENTIAL SMOOTHING
SIMPLE EXPONENTIAL SMOOTHING (SES)
• Suppose that the average level of phenomenon under
study (for eg demand of a commodity) is not changing
over time or if it is changing it is doing so slowly.
• This process can be modelled as
𝑦𝑡 = 𝑎 + 𝜀𝑡
where 𝑎 is the expected demand in any period and 𝜀𝑡 is
the random component having mean 0 and variance 𝜎 2 .
• At the end of time n, we have available a history 𝑦1 , 𝑦2 ,…,
𝑦𝑛 from which we wish to estimate 𝑎 and the forecast
error.
SIMPLE EXPONENTIAL SMOOTHING (SES)
• It is natural to forecast 𝑦𝑛+1 by means of a weighted sum
of the past observations
𝑦ො𝑛 1 = 𝑐0 𝑦𝑛 + 𝑐1 𝑦𝑛−1 + 𝑐2 𝑦𝑛−2 …
where 𝑐𝑖 are weights associated with the ith observation.
• Clearly, more weight should be given to recent
observations and less weight to observations further in
the past.
• SES gives geometric weights which decrease by a constant
ratio for every unit increase in the lag.
SIMPLE EXPONENTIAL SMOOTHING (SES)
• The weights are therefore defined as
𝑐𝑖 = 𝛼(1 − 𝛼)𝑖 ; 𝑖 = 0,1,2 …
where 𝛼 is a constant such that 0 < 𝛼 < 1.
• Thus,
𝑦ො𝑛 1
= 𝛼(1 − 𝛼)0 𝑦𝑛 + 𝛼(1 − 𝛼)1 𝑦𝑛−1 + 𝛼(1 − 𝛼)2 𝑦𝑛−2 …
• Note that even though the above equation implies an
infinite number of past observations, in practice there will
be only be a finite number of observations.
SIMPLE EXPONENTIAL SMOOTHING (SES)

• Now,
𝑦ො𝑛 1 = 𝛼𝑦𝑛 + (1 − 𝛼)1 𝛼𝑦𝑛−1 + 𝛼 1 − 𝛼 1 𝑦𝑛−2 …
= 𝛼𝑦𝑛 + 1 − 𝛼 𝑦ො𝑛−1 1 ….(1)
• Note that
𝑦ො1 1 = 𝑦1
• So that that (1) can be used recursively to compute
forecasts, by updating a previous forecast using the latest
observation.
SIMPLE EXPONENTIAL SMOOTHING (SES)

• The operation defined above is called simple exponential

smoothing ; 𝑦ො𝑛 1 is called the smoothed value or the
smoothed statistic; and 𝛼 is called the smoothing
constant.
• Thus simple exponential smoothing is a procedure that
adjusts the smoothed statistic by an amount that is
proportional to the most recent forecast error.
SIMPLE EXPONENTIAL SMOOTHING (SES)

• Equation (1) can also be written in an error-correction

form as
𝑦ො𝑛 1 = 𝛼 𝑦𝑛 − 𝑦ො𝑛−1 1 + 𝑦ො𝑛−1 1
= 𝛼𝑒𝑛 + 𝑦ො𝑛−1 1 ….(2)
where 𝑒𝑛 = 𝑦𝑛 − 𝑦ො𝑛−1 1 is the forecast error at time n.
• Either of the equations (1) or (2) can be used for obtaining
forecasts as both give identical forecasts.
CHOICE OF SMOOTHING CONSTANT
• The value of the smoothing constant 𝛼 depends on the
properties of the given time series.
• Values between 0.1 and 0.3 are commonly used and
produce a forecast that depends on a large number of
past observations.
• Values close to unity are rarely used and give a forecast
that depends much more on recent observations.
• When 𝛼 = 1 the forecast is equal to the most recent
observations.
CHOICE OF SMOOTHING CONSTANT
• The value of 𝛼 may be estimated from the past.
• Given a particular value of 𝛼, one-step-ahead forecasts
are produced iteratively through the series. And then the
sum of squares of the one step ahead prediction errors is
computed.
• This can be repeated for different values of 𝛼 , so that the
value that minimizes the sum of squares can be found.
EXPONENTIAL SMOOTHING METHODS
HOLT AND HOLT WINTER FORECASTING PROCEDURES
HOLT AND HOLT-WINTER FORECASTING

• Exponential smoothing can be easily generalised to deal

with time series containing trend and seasonal variation.
• When handling a trend with non seasonal data the
procedure is called Holt’s (two-parameter) exponential
smoothing.
• When handling a trend with seasonal data the procedure
is called Holt-Winter (three-parameter) exponential
smoothing.
HOLT’S EXPONENTIAL SMOOTHING
• Recall that the one step ahead forecast from SES is an
estimate of the local mean level of the series, so that it
can be regarded as a way of updating the local level of the
series 𝐿𝑡 and we can write
𝐿𝑡 = 𝛼𝑦𝑡 + (1 − 𝛼)𝐿𝑡−1
• Suppose we wish to include a trend term 𝑇𝑡 which is the
expected increase or decrease per unit time period in the
current level.
HOLT’S EXPONENTIAL SMOOTHING
• Then Holt gave a pair of equations for updating the values
𝐿𝑡 and 𝑇𝑡 as
𝐿𝑡 = 𝛼𝑦𝑡 + 1 − 𝛼 [𝐿𝑡−1 + 𝑇𝑡−1 ]
𝑇𝑡 = 𝛾[𝐿𝑡 − 𝐿𝑡−1 ] + 1 − 𝛾 𝑇𝑡−1
• So that the h-step-ahead forecast at time t will be
𝑦ො𝑡 ℎ = 𝐿𝑡 + ℎ𝑇𝑡 ; ℎ = 1, 2, 3, …
• There are two updating equation in this case and two
smoothing parameters 𝛼 and 𝛾 which are chosen in the
range of 0 to 1.
THE ANALYSIS OF TIME SERIES: AN INTRODUCTION
BY C. CHATFIELD