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Data-Snooping Biases in Tests of Financial Asset Pricing Models

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  • Andrew W. Lo
  • A. Craig MacKinlay

Abstract

We investigate the extent to which tests of financial asset pricing models may be biased by using properties of the data to construct the test statistics. Specifically, we focus on tests using returns to portfolios of common stock where portfolios are constructed by sorting on some empirically motivated characteristic of the securities such as market value of equity. We present both analytical calculations and Monte Carlo simulations that show the effects of this type of data-snooping to be substantial. Even when the sorting characteristic is only marginally correlated with individual security statistics, 5 percent tests based on sorted portfolio returns may reject with probability one under the null hypothesis. This bias is shown to worsen as the number of securities increases given a fixed number of portfolios, and as the number of portfolios decreases given a fixed number of securities. We provide an empirical example that illustrates the practical relevance of these biases.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3001.

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Date of creation: Jun 1989
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Publication status: published as The Review of Financial Studies, Vol. 3, No. 3, pp. 431-467, (1990).
Handle: RePEc:nbr:nberwo:3001

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  1. Connor, Gregory & Korajczyk, Robert A., 1988. "Risk and return in an equilibrium APT : Application of a new test methodology," Journal of Financial Economics, Elsevier, Elsevier, vol. 21(2), pages 255-289, September.
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  3. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  4. Josef Lakonishok, Seymour Smidt, 1988. "Are Seasonal Anomalies Real? A Ninety-Year Perspective," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 1(4), pages 403-425.
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  7. Merton, Robert C., 1985. "On the current state of the stock market rationality hypothesis," Working papers, Massachusetts Institute of Technology (MIT), Sloan School of Management 1717-85., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  8. Brown, Philip & Kleidon, Allan W. & Marsh, Terry A., 1983. "New evidence on the nature of size-related anomalies in stock prices," Journal of Financial Economics, Elsevier, Elsevier, vol. 12(1), pages 33-56, June.
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  13. Lehmann, Bruce N. & Modest, David M., 1988. "The empirical foundations of the arbitrage pricing theory," Journal of Financial Economics, Elsevier, Elsevier, vol. 21(2), pages 213-254, September.
  14. Blume, Marshall E, 1970. "Portfolio Theory: A Step Toward Its Practical Application," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 43(2), pages 152-73, April.
  15. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
  16. Kandel, Shmuel & Stambaugh, Robert F., 1987. "On correlations and inferences about mean-variance efficiency," Journal of Financial Economics, Elsevier, Elsevier, vol. 18(1), pages 61-90, March.
  17. Huberman, Gur & Kandel, Shmuel, 1987. " Mean-Variance Spanning," Journal of Finance, American Finance Association, American Finance Association, vol. 42(4), pages 873-88, September.
  18. Chan, K C & Chen, Nai-Fu, 1988. " An Unconditional Asset-Pricing Test and the Role of Firm Size as an Instrumental Variable for Risk," Journal of Finance, American Finance Association, American Finance Association, vol. 43(2), pages 309-25, June.
  19. Chamberlain, Gary, 1983. "Funds, Factors, and Diversification in Arbitrage Pricing Models," Econometrica, Econometric Society, Econometric Society, vol. 51(5), pages 1305-23, September.
  20. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, Econometric Society, vol. 57(5), pages 1121-52, September.
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