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Galton's Error and the under-representation of systematic risk

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  • Los, Cornelis A.

Abstract

Our methodology of 'complete identification,' using simple algebraic geometry, throws new light on the continued commitment of Galton's Error in finance and the resulting misinformation of investors. Mutual funds conventionally advertise their relative systematic market risk, or 'betas,' to potential investors based on incomplete measurement by unidirectional bivariate projections: they commit Galton's Error by under-representing their systematic risk. Consequently, far too many mutual funds are marketed as 'defensive' and too few as 'aggressive.' Using our new methodology we found that, out of a total of 3,217 mutual funds, 2,047 funds (63.7%) claimed to be defensive based on the current industry standard methodology, but only 608 (18.9%) actually are. This under-representation of systematic risk leads to inefficiencies in the capital allocation process, since biased betas lead to mis-pricing of mutual funds. Our complete bivariate projection produces a correct representation of the epistemic uncertainty inherent in the bivariate measurement of relative market risk. Our conclusions have also serious consequences for the proper 'bench-marking' and recent regulatory proposals for the mutual funds industry.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 23 (1999)
Issue (Month): 12 (December)
Pages: 1793-1829

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Handle: RePEc:eee:jbfina:v:23:y:1999:i:12:p:1793-1829

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  1. Cornelis A. Los, 1986. "Collinearity analysis of a simple money demand equation," Research Paper 8604, Federal Reserve Bank of New York.
  2. Harvey, Campbell R, 1991. " The World Price of Covariance Risk," Journal of Finance, American Finance Association, vol. 46(1), pages 111-57, March.
  3. Magnus, J.R. & Morgan, M.S., 1995. "An experiment in applied econometrics," Open Access publications from Tilburg University urn:nbn:nl:ui:12-153237, Tilburg University.
  4. Klepper, Steven & Leamer, Edward E, 1984. "Consistent Sets of Estimates for Regressions with Errors in All Variables," Econometrica, Econometric Society, vol. 52(1), pages 163-83, January.
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Cited by:
  1. Cornelis A Los, 2004. "System Identification in Noisy Data Environments: An Application to Six Asian Stock Markets," International Finance 0410005, EconWPA.
  2. Cornelis Los, 2004. "Measuring the Degree of Efficiency of Financial Market," Finance 0411003, EconWPA.
  3. Cornelis A. Los, 2004. "Model Uncertainty, Complexity and Rank in Finance," Econometrics 0411013, EconWPA.
  4. Los, Cornelis A. & Tungsong, Satjaporn, 2008. "Investment Model Uncertainty and Fair Pricing," MPRA Paper 8859, University Library of Munich, Germany.
  5. Cornelis A Los, 2004. "The Unscientific Incompleteness and Bias of Unidirectional Projections (= Regressions): A Questionnaire," Econometrics 0410011, EconWPA.
  6. Cornelis A. Los, 2005. "Were Cobb and Douglas Prejudiced? A Critical Re-analysis of their 1928 Production Model Identification," Econometrics 0502013, EconWPA.

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