Wrong Financial Research Might Be Putting Your Returns At Risk
When selecting a mutual fund the first thing every investor wants to look at is the historical returns. The higher and more consistent the returns mean the fund manager actually knows what they are doing in theory. However a new study suggests that the hot new funds and ETFs that are based on highly quantitative analysis backed up by academic research at top universities could be happening by pure luck and chance rather than a sophisticated algorithm.
Read the article over on Time for the research suggesting that the pure number of studies published over the last decade could be the result of chance.
There’s always some randomness in the world. Whether you are running a scientific lab study or looking at reams of data about past market returns, some of the correlations and patterns you’ll see are just going to be the result of luck, not a real effect. Here’s a very simple example of a spurious pattern from my Buffett story: You could have beaten the market since 1993 just by buying stocks with tickers beginning with the letters W, A, R, R, E, and N.
If you keep going back again and again (to the same data) with new tests, you increase your chances of turning up a random result. So maybe first you look to see if stocks of a given size outperform, then at stocks with a certain price relative to earnings, or price to asset value, or price compared to the previous month’s price… and so on, and so on. The more you look, the more likely you are to find something, whether or not there’s anything there.
Not all the models will be wrong and having an investing strategy of only investing in companies that start with the letter Z will most likely result in disaster. Remember, when selecting a mutual fund or where to invest your 401K it might be wiser to pick the fund with the long track record (10+ years) of steady performance rather than the hot fund with a new fund manager that might have earned 18% per year but has only existed for two years.
Read about the multiple testing and publication bias problems here. These findings could impact medical research and all the psychological studies mentioned on TED Talks as well.
About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.