Chapter 17 - Time Series Analysis and Forecasting

17.1 – Time Series Patterns

17.2 – Forecast Accuracy

17.3 – Moving Averages and Exponential Smoothing

Forecasting Methods: Qualitative

• Forecasting methods can be classified as qualitative or quantitative.

• Qualitative methods generally involve the use of expert judgment to develop forecasts.

• Such methods are appropriate when historical data on the variable being forecast are either
not applicable or unavailable.

• We will focus exclusively on quantitative forecasting methods in this chapter.

• Quantitative forecasting methods can be used when:

• Past information about the variable being forecast is available,

• The information can be quantified, and

• It is reasonable to assume the pattern of the past will continue

• In such cases, a forecast can be developed using a time series method or a causal method.

• Quantitative methods are based on an analysis of historical data concerning one or more
time series.

• A time series is a set of observations measured at successive points in time or over

successive periods of time.

• If the historical data used are restricted to past values of the series that we are trying to
forecast, the procedure is called a time series method.

• If the historical data used involve other time series that are believed to be related to the time
series that we are trying to forecast, the procedure is called a causal method.

• Time Series Analysis

• The objective of time series analysis is to discover a pattern in the historical data or time
series and then extrapolate the pattern into the future.

• The forecast is based solely on past values of the variable and/or past forecast errors.

• Causal Methods
 • Causal forecasting methods are based on the assumption that the variable we are forecasting
has a cause-effect relationship with one or more other variables.

• Looking at regression analysis as a forecasting tool, we can view the time series value that we
want to forecast as the dependent variable.

• If we can identify a good set of related independent, or explanatory, variables we may be

able to develop an estimated regression equation for forecasting the time series.

• Regression Analysis

• By treating time as the independent variable and the time series as a dependent variable,
regression analysis can also be used as a time series method.

• Time-series regression refers to the use of regression analysis when the sole independent
variable is time.

• Cross-sectional regression refers to the use of regression analysis when the independent
variable(s) is(are) something other than time.

Time Series Patterns

• A time series is a sequence of observations on a variable measured at successive points in

time or over successive periods of time.

• The pattern of the data is an important factor in understanding how the time series has
behaved in the past.

• If such behavior can be expected to continue in the future, we can use it to guide us in
selecting an appropriate forecasting method.

Time Series Plot

• A useful first step in selecting an appropriate forecasting method is to construct a time series
plot.

• A time series plot is a graphical presentation of the relationship between time and the time
series variable.

• Time is on the horizontal axis, and the time series values are shown on the vertical axis.
Example: Rosco Drugs

Sales of Comfort brand headache tonic (in bottles) for the past 10 weeks at Rosco Drugs are shown
below. Rosco Drugs would like to identify the underlying pattern in the data to guide it in selecting
an appropriate forecasting method.

The common types of data patterns that can be identified when examining a time series plot include:

• Horizontal

• Trend

• Seasonal

• Trend and Seasonal

• Cyclical

Horizontal Pattern

• A horizontal pattern exists when the data fluctuate around a constant mean.

• Changes in business conditions can often result in a time series that has a horizontal
pattern shifting to a new level.

• A change in the level of the time series makes it more difficult to choose an
appropriate forecasting method.

Trend Pattern
 • A time series may show gradual shifts or movements to relatively higher or lower
values over a longer period of time.

• Trend is usually the result of long-term factors such as changes in the population,
demographics, technology, or consumer preferences.

• A systematic increase or decrease might be linear or nonlinear.

• A trend pattern can be identified by analyzing multiyear movements in historical

data.

Seasonal Pattern

• Seasonal patterns are recognized by seeing the same repeating pattern of highs and
lows over successive periods of time within a year.

• A seasonal pattern might occur within a day, week, month, quarter, year, or some
other interval no greater than a year.

• A seasonal pattern does not necessarily refer to the four seasons of the year (spring,
summer, fall, and winter).

Trend and Seasonal Pattern

• Some time series include a combination of a trend and seasonal pattern.

• In such cases we need to use a forecasting method that has the capability to deal
with both trend and seasonality.

• Time series decomposition can be used to separate or decompose a time series into
trend and seasonal components.

Cyclical Pattern

• A cyclical pattern exists if the time series plot shows an alternating sequence of
points below and above the trend line lasting more than one year.

• Often, the cyclical component of a time series is due to multiyear business cycles.

• Business cycles are extremely difficult, if not impossible, to forecast.

• In this chapter we do not deal with cyclical effects that may be present in the time
series.

Selecting a Forecasting Method

• The underlying pattern in the time series is an important factor in selecting a forecasting
method.
 • Thus, a time series plot should be one of the first things developed when trying to determine
what forecasting method to use.

• If we see a horizontal pattern, then we need to select a method appropriate for this type of
pattern.

• If we observe a trend in the data, then we need to use a method that has the capability to
handle trend effectively.

Forecast Accuracy

• Measures of forecast accuracy are used to determine how well a particular forecasting
method is able to reproduce the time series data that are already available.

• Measures of forecast accuracy are important factors in comparing different forecasting

methods.

• By selecting the method that has the best accuracy for the data already known, we hope to
increase the likelihood that we will obtain better forecasts for future time periods.

• The key concept associated with measuring forecast accuracy is forecast error.

Forecast Error = Actual Value – Forecast

• A positive forecast error indicates the forecasting method underestimated the actual value.

• A negative forecast error indicates the forecasting method overestimated the actual value.

• Mean Error (ME)

A simple measure of forecast accuracy is the mean or average of the forecast errors. Because
positive and negative forecast errors tend to offset one another, the mean error is likely to be small.
Thus, the mean error is not a very useful measure.

• Mean Absolute Error (MAE)

This measure avoids the problem of positive and negative errors offsetting one another. It is the
mean of the absolute values of the forecast errors.

• Mean Squared Error (MSE)

This is another measure that avoids the problem of positive and negative errors offsetting one
another. It is the average of the squared forecast errors.

• Mean Absolute Percentage Error (MAPE)

The size of MAE and MSE depend upon the scale of the data, so it is difficult to make comparisons for
different time intervals. To make such comparisons we need to work with relative or percentage
error measures. The MAPE is the average of the absolute percentage errors of the forecasts.
 • To demonstrate the computation of these measures of forecast accuracy we will introduce
the simplest of forecasting methods.

• The naive forecasting method uses the most recent observation in the time series as the
forecast for the next time period.

Example: Rosco Drugs

Sales of Comfort brand headache tonic (in bottles) for the past 10 weeks at Rosco Drugs are shown
below. If Rosco uses the naïve forecast method to forecast sales for weeks 2 – 10, what are the
resulting MAE, MSE, and MAPE values?
Naive Forecast Accuracy

Moving Averages and Exponential Smoothing

Now we discuss three forecasting methods that are appropriate for a time series with a horizontal
pattern:

• Moving Averages

• Weighted Moving Averages

• Exponential Smoothing

• They are called smoothing methods because their objective is to smooth out the random
fluctuations in the time series.

• They are most appropriate for short-range forecasts.

Moving Averages

The moving averages method uses the average of the most recent k data values in the time series as
the forecast for the next period.

Each observation in the moving average calculation receives the same weight.

The term moving is used because every time a new observation becomes available for the time
series, it replaces the oldest observation in the equation.

As a result, the average will change, or move, as new observations become available.

• To use moving averages to forecast, we must first select the order 𝑘, or number of time
series values, to be included in the moving average.

• A smaller value of 𝑘 will track shifts in a time series more quickly than a larger value of 𝑘.

• If more past observations are considered relevant, then a larger value of 𝑘 is better.
Example: Rosco Drugs

If Rosco Drugs uses a 3-period moving average to forecast sales, what are the forecasts for weeks 4-
11?

3-MA Forecast Accuracy

The 3-week moving average approach provided more accurate forecasts than the naive approach.

Weighted Moving Averages

To use this method we must first select the number of data values to be included in the average.

Next, we must choose the weight for each of the data values.

The more recent observations are typically given more weight than older observations.

For convenience, the weights should sum to 1.

An example of a 3-period weighted moving average (3WMA) is:

3WMA = 0.2(110) + 0.3(115) + 0.5(125) = 119

• In this example the weights are 0.2, 0.3, and 0.5 (which sum to 1).

• 125 is the most recent of the three observations.

Exponential Smoothing

• This method is a special case of a weighted moving averages method; we select only the
weight for the most recent observation.

• The weights for the other data values are computed automatically and become smaller as
the observations grow older.

• The exponential smoothing forecast is a weighted average of all the observations in the time
series.

• The term exponential smoothing comes from the exponential nature of the weighting
scheme for the historical values.

Exponential Smoothing Forecast

With algebraic manipulation, we can rewrite

We see that the new forecast 𝐹(𝑡+1) is equal to the previous forecast 𝐹𝑡 plus an adjustment, which is 𝛼
times the most recent forecast error, 𝑌𝑡−𝐹𝑡.

Example: Rosco Drugs

If Rosco Drugs uses exponential smoothing to forecast sales, which value for the smoothing constant
𝛼, 0.1 or 0.8, gives better forecasts?
Using Smoothing Constant Value 𝛼 = 0.1

Using Smoothing Constant Value 𝛼 = 0.8

Exponential Smoothing (𝜶 = 0.1)

Forecast Accuracy

Exponential smoothing (with 𝛼 = 0.1) provided less accurate forecasts than the 3-MA approach.

Exponential Smoothing (α = 0.8)

Forecast Accuracy

Exponential smoothing (with α = 0.8) provided more accurate forecasts than ES with α = 0.1, but less
accurate than the moving average (with 𝑘 = 3).