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To Y
 means to predict the values of one or more series over time. For example, we may want to
predict the expected demand for a line of products or services in order to allocate resources for
manufacturing or distribution. Because planning decisions take time to implement, forecasts are an
essential tool in many planning processes.

Methods of modeling time series assume that history repeats itself²if not exactly, then closely enough
that by studying the past, we can make better decisions in the future. To predict sales for next year, for
example, we would probably start by looking at this year¶s sales and work backward to figure out what
trends or patterns, if any, have developed in recent years. But patterns can be difficult to gauge. If the
sales increase several weeks in a row, for example, is this part of a seasonal cycle or the beginning of a
long-term trend?

Using statistical modeling techniques, we can analyze the patterns in the past data and project those
patterns to determine a range within which future values of the series are likely to fall. The result is more
accurate forecasts on which to base our decisions.





A m
 is an ordered collection of measurements taken at regular intervals²for example, daily
stock prices or weekly sales data. The measurements may be of anything of interest, and each series can
generally be classified as one of the following:

(c Æm A series that is to be forecasted.

(c Ý
m A series that may help to explain the target²e.g using an advertising budget to predict
sales. Predictors can only be used with ARIMA models.
(c ô m A special predictor series used to account for predictable recurring incidents²e.g sales
promotions.
(c ²m m  A special predictor series used to account for one-time past incidents²e.g a financial
recession or employee strike.

The intervals can represent any unit of time, but the interval must be the same for all measurements.
Moreover, any interval for which there is no measurement must be set to the missing value. Thus, the
number of intervals with measurements (including those with missing values) defines the length of time
of the historical span of the data.

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Studying the past behavior of a series will help us identify patterns and make better forecasts.
When plotted, many time series exhibit one or more of the following features:

(c Trends
(c Seasonal and nonseasonal cycles
(c Pulses and steps
(c gutliers
(c Intermittent demandc

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A 
 is a gradual upward or downward shift in the level of the series or the tendency of the series
values to increase or decrease over time.

+


c
c

Trends are either ž ž or

ž ž, but a single series can exhibit both types. Historically, series plots of the
stock market index show an upward global trend. Local downward trends have appeared in times of
recession, and local upward trends have appeared in times of prosperity.

Trends can also be either ž 
or  ž 
. Linear trends are positive or negative additive increments
to the level of the series, comparable to the effect of simple interest on principal. Nonlinear trends are
often multiplicative, with increments that are proportional to the previous series value(s).

Global linear trends are fit and forecast well by both exponential smoothing and ARIMA models. In
building ARIMA models, series showing trends are generally differenced to remove the effect of the
trend.
c

 
9


A  ž ž is a repetitive, predictable pattern in the series values.



 




c c
c



c
c
Seasonal cycles are tied to the interval of the series. For instance, monthly data typically cycles over
quarters and years. Series that show a seasonal cycle are said to exhibit  ž . Seasonal patterns are
useful in obtaining good fits and forecasts, and there are exponential smoothing and ARIMA models that
capture seasonality.
c
V  
9


A   ž ž is a repetitive, possibly unpredictable, pattern in the series values.

V
 




Some series, such as unemployment rate, clearly display cyclical behavior; however, the periodicity of the
cycle varies over time, making it difficult to predict when a high or low will occur. gther series may have
predictable cycles but do not neatly fit into the Gregorian calendar or have cycles longer than a year e.g,
the tides follow the lunar calendar, international travel and trade related to the glympics swell every four
years, and there are many religious holidays whose Gregorian dates change from year to year.

Nonseasonal cyclical patterns are difficult to model and generally increase uncertainty in forecasting. The
stock market, for example, provides numerous instances of series that have defied the efforts of
forecasters. All the same, nonseasonal patterns must be accounted for when they exist. In many cases, we
can still identify a model that fits the historical data reasonably well, which gives you the best chance to
minimize uncertainty in forecasting.

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Many series experience abrupt changes in level. They generally come in two types:
(c A sudden, m
shift, or V ž, in the series level
(c A sudden,  
 mshift, or V, in the series levelc
c
When steps or pulses are observed, it is important to find a plausible explanation. Time series models are
designed to account for gradual, not sudden, change. As a result, they tend to underestimate pulses and be
ruined by steps, which lead to poor model fits and uncertain forecasts. (Some instances of seasonality may
appear to exhibit sudden changes in level, but the level is constant from one seasonal period to the next.)

If a disturbance can be explained, it can be modeled using an 
  or  . e.g. after the collapse
of Lehman Brothers in September 2008, the lack of investor confidence caused a recession in the US and
European economies, which then returned to normal levels in 2010. By specifying a V  
 

c c
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c
c
for the month of the Lehman Brothers collapse, we can improve the fit of your model, thus indirectly
improving our forecasts. e.g. a retail store might find that sales were much higher than usual on the day all
items were marked 50% off. By specifying the 50%-off promotion as a recurring  , we can improve
the fit of your model and estimate the effect of repeating the promotion on future dates.c
c


  


c
c
g 


Shifts in the level of a time series that cannot be explained are referred to as ž 
. These observations
are inconsistent with the remainder of the series and can dramatically influence the analysis and,
consequently, affect the forecasting ability of the time series model.

(c S m  m An additive outlier appears as a surprisingly large or small value occurring for a
single observation. Subsequent observations are unaffected by an additive outlier. Consecutive
additive outliers are typically referred to    ž 
V.
(c ²
m 
 m An innovational outlier is characterized by an initial impact with effects
lingering over subsequent observations. The influence of the outliers may increase as time proceeds.
(c ]  m m For a level shift, all observations appearing after the outlier move to a new
level. In contrast to additive outliers, a level shift outlier affects many observations and has a
permanent effect.
(c +
 m
 m Transient change outliers are similar to level shift outliers, but the
effect of the outlier diminishes exponentially over the subsequent observations. Eventually, the series
returns to its normal level.
(c 

S m  m A seasonal additive outlier appears as a surprisingly large or small
value occurring repeatedly at regular intervals.
(c ]

+ m A local trend outlier yields a general drift in the series caused by a pattern in
the outliers after the onset of the initial outlier.

The following figure displays several types of outliers commonly occurring in time series. The blue lines
represent a series without outliers. The red lines suggest a pattern that might be present if the series
contained outliers. These outliers are all classified as 
    because they affect only the mean
level of the series.




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c
c
c
S  

 

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Autocorrelation and partial autocorrelation are measures of association between current and past series
values and indicate which past series values are most useful in predicting future values. With this
knowledge, we can determine the order of processes in an ARIMA model. More specifically,
(c S m

m  
m SAt lag m, this is the correlation between series values that
are mintervals apart.
(c Ý
m

m

m  
m ÝSAt lag m, this is the correlation between series values
that are mintervals apart, accounting for the values of the intervals between.


c c
c



c
c
S
  



c
c
The x axis of the ACF plot indicates the lag at which the autocorrelation is computed; the y axis indicates
the value of the correlation (between -1 and 1). e.g. a spike at lag 1 in an ACF plot indicates a strong
correlation between each series value and the preceding value, a spike at lag 2 indicates a strong
correlation between each value and the value occurring two points previously, and so on.
-c A positive correlation indicates that large current values correspond with large values at the specified
lag; a negative correlation indicates that large current values correspond with small values at the
specified lag.
-c The absolute value of a correlation is a measure of the strength of the association, with larger absolute
values indicating stronger relationships.c
c
c
c




 

Transformations are often useful for stabilizing a series before estimating models. This is particularly
important for ARIMA models, which require series to be  
 before models are estimated. A
series is stationary if the global level (mean) and average deviation from the level (variance) are constant
throughout the series.
While most interesting series are not stationary, ARIMA is effective as long as the series can be made
stationary by applying transformations, such as the natural log, differencing, or seasonal differencing.




m
   m


m Series in which the variance changes over time can often
be stabilized using a natural log or square root transformation. These are also called functional
transformations.
(c V
m 
The natural logarithm is applied to the series values.
(c 
mThe square root function is applied to the series values.
Natural log and square root transformations cannot be used for series with negative values.

] m
   m


m A slow decline of the values in the ACF indicates that each series
value is strongly correlated with the previous value. By analyzing the change in the series values, we
obtain a stable level.
(c 
 
The differences between each value and the previous value in the series are
computed, excepting, of course, the oldest value in the series. This means that the differenced series
will have one less value than the original series.
(c 

 
Identical to simple differencing, except that the differences between each
value and the previous seasonal value are computed.

c c
c



c
c
When either simple or seasonal differencing is simultaneously in use with either the log or square
root transformation, the variance stabilizing transformation is always applied first. When simple
and seasonal differencing are both in use, the resulting series values are the same whether simple
differencing or seasonal differencing is applied first.

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Predictor series include related data that may help explain the behavior of the series to be forecast. e.g, a
Web- or catalog-based retailer might forecast sales based on the number of catalogs mailed, the number
of phone lines open, or the number of hits to the company Web page.

While adding predictors may improve a model¶s ability to fit the historical data, it doesn¶t necessarily
mean that the model does a better job of forecasting, so the added complexity may not be worth the
trouble. Ideally, the goal should be to identify the simplest model that does a good job of forecasting.

As a general rule, it is recommended that the number of predictors should be less than the sample size
divided by 15 (at most, one predictor per 15 cases).
c
c



 

ô V  ž   
is a method of forecasting that uses weighted values of previous series
observations to predict future values. As such, exponential smoothing is not based on a theoretical
understanding of the data. It forecasts one point at a time, adjusting its forecasts as new data come in. The
technique is useful for forecasting series that exhibit trend, seasonality, or both.

 


  

  
 

 models provide more sophisticated methods for
modeling trend and seasonal components than do exponential smoothing models, and, in particular, they
allow the added benefit of including independent (predictor) variables in the model. This involves
explicitly specifying autoregressive and moving average orders as well as the degree of differencing.

In practical terms, ARIMA models are most useful in explaining the behavior of the series being forecast,
by including predictors such as the number of catalogs mailed or the number of hits to a company Web
page. Exponential smoothing models describe the behavior of the time series without attempting to
understand why it behaves as it does. e.g a series that historically has peaked every 12 months will
probably continue to do so even if you don¶t know why.

] 





 

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(c In order to forecast using this model, the same time span and interval information must be used with
the same series for both the target variable and predictor variables.
(c The further into the future you try to predict, the less effective the model will become.
(c Time series model must be re-estimated and forecasted again, each time new data is available.

c c
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c