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Galton's Error and the Under-Representation of Systematic Risk

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Author Info
CORNELIS A. LOS (Kent State University)

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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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Paper provided by EconWPA in its series Finance with number 0409041.

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Date of creation: 13 Sep 2004
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Handle: RePEc:wpa:wuwpfi:0409041

Note: Type of Document - pdf. Los, Cornelis Albertus, 'Galton's Error and the Under-Representation of Systematic Risk' .
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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
G23 - Financial Economics - - Financial Institutions and Services - - - Pension Funds; Other Private Financial Institutions

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. 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. [Downloadable!] (restricted)
  2. Cornelis A. Los, 1986. "Collinearity analysis of a simple money demand equation," Research Paper 8604, Federal Reserve Bank of New York.
  3. Harvey, Campbell R, 1991. " The World Price of Covariance Risk," Journal of Finance, American Finance Association, vol. 46(1), pages 111-57, March. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Cornelis A. Los, 2004. "Model Uncertainty, Complexity and Rank in Finance," Econometrics 0411013, EconWPA. [Downloadable!]
  2. Cornelis A Los, 2004. "The Unscientific Incompleteness and Bias of Unidirectional Projections (= Regressions): A Questionnaire," Econometrics 0410011, EconWPA. [Downloadable!]
  3. Cornelis Los, 2004. "Measuring the Degree of Efficiency of Financial Market," Finance 0411003, EconWPA. [Downloadable!]
  4. Cornelis A. Los, 2005. "Were Cobb and Douglas Prejudiced? A Critical Re-analysis of their 1928 Production Model Identification," Econometrics 0502013, EconWPA. [Downloadable!]
  5. Los, Cornelis A. & Tungsong, Satjaporn, 2008. "Investment Model Uncertainty and Fair Pricing," MPRA Paper 8859, University Library of Munich, Germany. [Downloadable!]
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