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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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  • Los, Cornelis A., 1999. "Galton's Error and the under-representation of systematic risk," Journal of Banking & Finance, Elsevier, vol. 23(12), pages 1793-1829, December.
    • Handle: RePEc:eee:jbfina:v:23:y:1999:i:12:p:1793-1829
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    1. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
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    Cited by:

    1. Cornelis A. Los, 2005. "Were Cobb and Douglas Prejudiced? A Critical Re-analysis of their 1928 Production Model Identification," Econometrics 0502013, University Library of Munich, Germany.
    2. Cornelis A Los, 2004. "The Unscientific Incompleteness and Bias of Unidirectional Projections (= Regressions): A Questionnaire," Econometrics 0410011, University Library of Munich, Germany.
    3. Los, Cornelis A., 2006. "System identification in noisy data environments: An application to six Asian stock markets," Journal of Banking & Finance, Elsevier, vol. 30(7), pages 1997-2024, July.
    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. "Model Uncertainty, Complexity and Rank in Finance," Econometrics 0411013, University Library of Munich, Germany.
    6. Cornelis Los, 2004. "Measuring the Degree of Efficiency of Financial Market," Finance 0411003, University Library of Munich, Germany.

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    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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