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Saturday, January 13, 2007

If You Knew How To Beat The Market, Would You Tell Anyone?

I'm always amused by financial seminars that offer to tell you (for a fee) how to beat the market with no risk.

The question to ask anyone who tells you they can do this is "If you really knew know how to do this, why would you sell the information?" Why not just use it yourself? After all if it's so profitable, just pay employees to do it for you.

There's a direct parallel in financial economics research. Let's assume that you discover a market anomaly that provides abnormal risk adjusted profits (like, "markets are slow to adjust to positive earnings surprises", or "small firms have abnormally high risk adjusted returns in January").

If you found this, why would you publish it? If you didn't, you could trade on it and make a lot of money. On the other hand, if you publish it, others will start trading on it and the abnormal profits will disappear.

Colby Wright (a Ph.D. student at Florida State) examined this question as part of his dissertation. Here's the abstract of his paper "So You Discovered An Anomaly... Gonna Publish it?":
If publishing an anomaly leads to the dissipation of its profitability, a notion that has mounting empirical support, then publishing a highly profitable market anomaly seems to be irrational behavior. This paper explores the issue by developing and empirically testing a theory that argues that publishing a market anomaly may, in fact, be rational behavior. The theory predicts that researchers with few (many) publications and lesser (stronger) reputations have the highest (lowest) incentive to publish market anomalies. Employing probit models, simple OLS regressions, and principal component analysis, I show that (a) market anomalies are more likely to be published by researchers with fewer previous publications and who have been in the field for a shorter period of time and (b) the profitability of published market anomalies is inversely related to the common factor spanning the number of publications the author has and the number of years that have elapsed since the professor earned his Ph.D. The empirical results suggest that the probability of publishing an anomaly and the profitability of anomalies that are published are inversely related to the reputation of the authors. These results corroborate the theory that publishing an anomaly is rational behavior for an author trying to establish his or her reputation.
A link to the piece is available on SSRN here.

This basically means that a newer untenured faculty will more likely publish the anomaly because
  1. It builds his reputational capital, thus making it more likely that he'll be able to "trade up" to a better school/higher salary/lower teaching load, more research support, etc...
  2. It increases his chances of getting tenure
  3. He really doesn't have the capital to take advantage of the anomaly anyway.
On the other hand, a tenured senior professor at a top school is more likely to keep his mouth shut and trade on the information.

This also implies that the stuff that tenured senior faculty publish is less likely to be really, really useful in generating abnormal profits.

HT: Hedgefundguy at The Alpha and Omega

Update: Barry Ritholtz makes a good point that I hadn't considered in the comments:
...some identified anomalies work better as marketing for products than they do as true trading insight. Consider a well tested investing advantage that provides an annualized 50 or even 150 basis point advantage versus the S&P500 over 10 years. What do you do with that? They may outperform, but any advantage to the discoverer is contingent on attracting significant assets. So you write a book ("Dogs of the Dow"), sell a newsletter (StockTrader's Almanac "Sell in May"). Maybe you can even create a mutual fund firm (Wisdom Tree) for it.

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