Finance is Not Excused: Why Finance Should Not Flout Basic Principles of Statistics

Forthcoming, Significance (Royal Statistical Society), 2021

11 Pages Posted: 29 Jul 2021

See all articles by David H. Bailey

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; Abu Dhabi Investment Authority; True Positive Technologies

Date Written: July 28, 2021

Abstract

Several features of financial research make it particularly prone to the occurrence of false discoveries. First, the probability of finding a positive (profitable investment strategy) is very low, due to intense competition. Second, true findings are mostly short-lived, as a result of the non-stationary nature of financial systems. Third, unlike in the natural sciences, it is rarely possible to verify statistical findings through controlled experiments. Finance’s inability to conduct controlled experiments makes it virtually impossible to debunk a false claim. One would hope that, in such a field, researchers would be particularly careful when conducting statistical inference. Sadly, the opposite is true.

Tenure-seeking researchers publish thousands of academic articles that promote dubious investment strategies, without controlling for multiple testing. Some of those articles are written for, funded, or promoted by investment firms with a commercial interest. As a consequence, today’s academic finance exhibits some resemblance with medicine’s predicament during the 1950-2000 period, when Big Tobacco paid for thousands of studies in support of their bottom line. Unlike finance, medical journals today impose strict controls for multiple testing. Academic finance’s denial of its replication crisis risks its branding as a pseudoscience.

Keywords: Multiple testing, selection bias, publication bias, false discovery rate, true positive rate, deflated Sharpe ratio

JEL Classification: G0, G1, G2, G15, G24, E44

Suggested Citation

Bailey, David H. and López de Prado, Marcos, Finance is Not Excused: Why Finance Should Not Flout Basic Principles of Statistics (July 28, 2021). Forthcoming, Significance (Royal Statistical Society), 2021, Available at SSRN: https://ssrn.com/abstract=3895330 or http://dx.doi.org/10.2139/ssrn.3895330

David H. Bailey

Lawrence Berkeley National Laboratory ( email )

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Berkeley, CA 94720
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HOME PAGE: http://www.davidhbailey.com

University of California, Davis ( email )

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Apt 153
Davis, CA 95616
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HOME PAGE: http://www.davidhbailey.com

Marcos López de Prado (Contact Author)

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

Abu Dhabi Investment Authority ( email )

211 Corniche Road
Abu Dhabi, Abu Dhabi PO Box3600
United Arab Emirates

HOME PAGE: http://www.adia.ae

True Positive Technologies ( email )

NY
United States

HOME PAGE: http://www.truepositive.com

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