SUPPLEMENT 3

ADVANCED EXPONENTIAL SMOOTHING

The exponential smoothing technique presented in the previous section is a mechanism for combining information from present actual data and forecasts of present data (which incorporate information from previous data) to forecast data for ensuing time periods. Weights are assigned by the forecaster to the importance of the current actual data versus the forecast of the current data in making the forecast. There are other factors that can be taken into consideration in exponential smoothing. In particular, the time-series components, trend, and seasonal effects can be incorporated into the forecast when they exist. First, we will consider exponential smoothing which includes trend effects.

EXPONENTIAL SMOOTHING WITH TREND EFFECTS: HOLTS METHOD

One exponential smoothing technique which includes trend effects is Holts two-parameter method. Holts technique uses weights to smooth the trend in a manner similar to that which we used in exponential smoothing in the previous section. Holts two-parameter method uses the following three equations to accomplish this: Smoothed Values: Et = Xt + (1 )(Et1 + Tt1) Trend Term Update: Tt = (Et Et1) + (1 )Tt1 Forecast for Next Period: Ft+1 = Et + Tt For k periods in the future: Ft+k = Et + kTt In simple exponential smoothing, the smoothed values were the forecasts. The next smoothed value was determined by weighing the actual value by and the previous forecast (the last smoothed value) by 1 . Now we have introduced trend into consideration. Notice from the last two equations above that the forecast is now a function of both the smoothed value and the trend. Thus, we have assigned a new notation for the smoothed values, E, and reserved F for the forecast. T denotes the trend. With simple exponential smoothing there was only one smoothing constant, . Since trend is part of the forecasting process here, we introduce a weight for trend, . These two weights can be the same or different. As before, the weights determine how much emphasis is to be placed on recent values versus previous values. Higher values of and place more emphasis on recent values. An examination of the equations can enlighten us about the process. The last two equations are for computing the forecasts. To forecast the next period, use Ft+1 = Et + Tt. To forecast more than one period in the future using current information use Ft+1 = Et + kTt. k is the number of periods in the future to be forecast. For example, if you want to forecast 3 periods in the future, use Ft+3 = Et + 3Tt . Notice that the forecast for the next period is a function of the smoothed value of this period and the trend for this period. In calculating the new smoothed value using E = Xt t + (1 )(Et1 + Tt1), the last term, (Et1 + Tt1), is simply the forecast for this period. Substituting this notion into the smoothing formula results in: Et = Xt + (1 )(Ft) This is analogous to what was done in simple exponential smoothing to update the smoothed value. The smoothed value is a function of the actual value and the forecast. S3-1

S3-2

SUPPLEMENT 3 ADVANCED EXPONENTIAL SMOOTHING

The trend term is updated at each step of the process using the second equation, Tt = (Et Et1) + (1 )Tt1. Essentially, the updated trend term is a weight of the difference in this periods smoothed value and last periods smoothed value (a search for current rate of increase or decrease) and a weight of the old trend value. As an example of the use of this technique, we will apply Holts two-parameter method to the housing starts data presented in Demonstration Problem 16.3. We have chosen = 0.8 and = 0.4 as the weights. Initializing the process can be a choice for the forecaster. Since we have no historical data given before 1984 in the problem, we will start with a trend of 0. If there is some historical trend in the process being studied, some researchers will use that trend as the initial value. Notice also that while the first actual value is the forecast for period 2 (1985), the first smoothed value is the first actual value (1750 for 1984). Shown here are the calculations for 1985, 1986, and 1987.
Year 1984 1985 1986 1987 Xt 1750 1742 1805 1620 Et 1750 Tt 0 Ft error

Using the initial values for 1984, the forecast for 1985 can be obtained: F1985 = E1984 + T1984 = 1750 + 0 = 1750 We can now update the smoothed value for 1985 as: E1985 = 0.8 X1985 + (1 0.8)(F1985) = 0.8(1742) + 0.2(1750) = 1743.6 The trend is now updated by: T1985 = 0.4 (E1985 E1984) + (1 0.4 )T1984 = 0.4(1743.6 1750) + 0.6(0) = 2.6 The forecast for the 1986 year is: F1986 = E1985 + T1985 = 1743.6 + (2.6) = 1741.0 The smoothed value for 1986 is: E1986 = 0.8 X1986 + (1 0.8)(F1986) = 0.8(1805) + 0.2(1741) = 1792.2 The trend is updated: T1986 = 0.4 (E1986 E1985) + (1 0.4 )T1985 = 0.4(1792.2 1743.6) + 0.6(2.6) = 17.9 The forecast for the 1987 year : F1987 = E1986 + T1986 = 1792.2 + 17.9 = 1810.1 The results of this exponential smoothing process including trend are shown below in Table S3.1. The error of the forecasts is measured using MSE, MAD, and MAPE. Comparing the results here to those obtained in Demonstration Problem 16.3 shows that this process produced smaller error that for simple exponential smoothing with = 0.2 or 0.5. However, simple exponential smoothing with = 0.8 produced a smaller MSE than were obtained here with the trend included. Note that Table S3.1 includes the forecast for 1999, which is computed by summing the smoothed value of 1998 and the trend for 1998. Suppose a forecaster wants to forecast the new housing starts for the year 2004 using the 1998 values. Since 2004 is six years beyond 1998, k = 6. The forecast is: F1998+6 = E1998 + 6T1998 = 1464.4 + 6(15.7) = 1558.6

EXPONENTIAL SMOOTHING WITH BOTH TREND AND SEASONALITY: WINTERS METHOD

In a manner similar to that used by Holts two-parameter method, Winters method accomplishes exponential smoothing but also includes a procedure which incorporates seasonality to go with trend. The formulas for using Winters Method are:

EXPONENTIAL SMOOTHING WITH BOTH TREND AND SEASONALITY: WINTERS METHOD S3-3

TABLE S3.1
Results of Holts Two-Parameter Exponential Smoothing on Housing Starts Data

Year 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Xt 1750 1742 1805 1620 1488 1376 1193 1014 1200 1288 1457 1354 1477 1475 1450

Et 1750 1743.6 1792.2 1658.0 1513.4 1386.8 1211.6 1027.4 1135.1 1247.8 1418.4 1382.5 1464.6 1483.4 1464.5

Tt 0 2.6 17.9 42.9 83.6 100.8 130.6 152.0 48.1 16.2 78.0 32.4 52.3 38.9 15.8

Ft 1750 1741 1810.1 1615.1 1429.8 1286 1081 875.4 1087 1264 1496.4 1414.9 1516.9 1522.3 1480.3

error 8 64 190.1 127.1 53.8 93 67 324.6 201 193 142.4 62.1 41.9 72.3

MAD = 117.2 MSE = 20,472,6 MAPE = 8.65%

Smoothed Values: Trend Term Update: Seasonality Update: Forecast for Next Period: for k periods in the future:

Et = (Xt StL ) + (1 )(Et1 + Tt1) Tt = (Et Et1) + (1 )Tt1 St = (Xt Et) + (1 g ) StL Ft+1 = (Et + Tt)StL+1 Ft+k = (Et + kTt )StL+k

Compare these formulas with those used in Holts method. The equation for the smoothed value is the same as with Holts method except that in place of the actual value, there is the quotient of the actual over the seasonal. This adjusts the actual value for seasonality. The trend equation is the same. The new equation is the seasonality equation: St = (Xt Et) + (1 ) StL Winters method introduces a third weight, , to go along with and . is a weight between 0 and 1 that is placed on the present seasonality effect which is measured by the ratio of the current actual value to the current smoothed value. The old seasonal value, StL, is weighted by 1 . The forecast is similar to Holts except that the sum of the smoothed value and the trend value is multiplied by the season effect to produce the next forecast. Shown below in Table S3.2 are the results of applying Winters method to the housing start data from Demonstration Problem 16.3 using = .8, = .4, and = .3. One of the issues in using Winters method is what value to use initially for the seasonal effects. We have chosen 1 as an initial value here. The calculations for 1985, 1986, and the forecast of 1987 are:
Year 1984 1985 1986 1987 Xt 1750 1742 1805 1620 Et 1750 Tt 0 St 1 Ft error

S3-4

SUPPLEMENT 3 ADVANCED EXPONENTIAL SMOOTHING

Using the initial values for 1984, the forecast for 1985 can be obtained: F1985 = (E1984 + T1984)S1984 = (1750 + 0)1 = 1750 We can now update the smoothed value for 1985 as: E1985 = 0.8 (X1985 S1984) + (1 0.8)(E1984 + T1984) = 0.8(1742 1) + 0.2(1750 + 0) = 1743.6 The trend is now updated by: T1985 = 0.4(E1985 E1984) + (1 0.4 )T1984 = 0.4(1743.6 1750) + 0.6(0) = 2.6 The seasonal value is updated by: S1985 = 0.3(X1985 E1985) + (1 0.3)S1984 = 0.3(1742 1743.6) + .7(1) = 1.00 The forecast for the 1986 year is: F1986 = (E1985 + T1985 ) S1985 = (1743.6 2.6)(1.00) = 1741 We can now update the smoothed value for 1986 as: E1986 = 0.8(X1986 S1985) + (1 0.8)(E1985 + T1985) = 0.8(1805 1.00) + 0.2(1743.6 2.6) = 1792.2 The trend is now updated by: T1986 = 0.4(E1986 E1985) + (1 0.4 )T1985 = 0.4(1792.2 1743.6) + 0.6(2.6) = 17.9 The seasonal value is updated by: S1986 = 0.3(X1986 E1986) + (1 0.3)S1985 = 0.3(1805 1792.2) + .7(1.00) = 1.00 The forecast for the 1987 year is: F1987 = (E1986 + T1986) S1986 = (1792.2 + 17.9)(1.00) = 1810.1 All three measurements of error are smaller for Winters than for Holts methodology. Winters method yielded the lowest MAPE (8.54%) for any of the exponential smoothing techniques presented on these data including the simple exponential smoothing with alpha = 0.8. There are many possible combinations of , , and that can be explored

TABLE S3.2
Results of Winters Method on Housing Starts Data

Year 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Xt 1750 1742 1805 1620 1488 1376 1193 1014 1200 1288 1457 1354 1477 1475 1450

Et 1750 1743.6 1792.2 1658.0 1522.2 1397.5 1221.4 1035.7 1144.7 1241.8 1398.2 1353.8 1439.4 1460.4 1442.8

Tt 0 2.6 17.9 42.9 80.1 97.9 129.2 151.8 47.5 10.3 68.7 23.5 48.3 37.4 15.4

St 1.00 1.00 1.00 0.99 0.99 0.99 0.99 0.99 1.01 1.02 1.03 1.02 1.02 1.02 1.02

Ft 1750.0 1741.0 1810.1 1598.9 1427.7 1286.6 1081.3 875.1 1108.2 1277.1 1510.9 1404.9 1517.5 1527.8

error 8 64 190.1 110.9 51.7 93.6 67.3 324.9 179.8 179.9 156.9 72.1 42.5 77.8 1487.4

MAD = 115.7 MSE = 19,749.1 MAPE = 8.54%

PRACTICE PROBLEMS S3-5

some of which might improve on the solutions shown here. Computer forecasting programs are good for exploring and attempting to maximize the various weights.

SOME PRACTICE PROBLEMS

1. Use Holts two-parameter method to exponentially smooth the data given in problem 16.7. Use = .5 and try both = .3 and = .7. Calculate MAD and compare the two analyses. How did these compare to the results obtained in 16.7? 2. Use Winters method to exponentially smooth the data given in problem 16.7. Use = .5, = .3, and = .7. Measure the error using MAD. How did you do? Compare the results obtained here to those in problem 1. 3. Use Holts two-parameter method to exponentially smooth the data given in problem 16.9. Let = .9 and = .4. Use Winters method to forecast the data given in problem 15.14 using = .9, = .4, and = .6. Compare the two forecasts using MAPE. Summarize your findings. How did these two methods compare to the results obtained in problem 15.14 using = .9?