312 The Basics of financial economeTrics
Influence of emotions
It is the exact same objectivity that researchers are proud of regarding their
procedures that often leads to the question, “If everyone has the financial
econometric models, will they not get the same answers?” The “overmining”
on the same data set using simple linear models almost eliminates the pos-
sibility of gaining excess risk-adjusted returns (or alpha in the parlance of
the financial profession).
Pessimism resulting from the competition of quantitative research also
justifies the need to include some form of what the economist John Maynard
Keynes called “animal spirit” in the decision process—how emotions influ-
ence human behavior.^6 Being able to do so is also probably the single most
important advantage that traditional security analysis can claim over quan-
titative approach. Casual observations provide ample examples that investor
behavior determining market pricing follows neither symmetric nor linear
patterns: investors tend to react to bad news much differently than to good
news;^7 information in more recent periods is overweighted in the decision
process;^8 investors ignore the probability of the event but emphasize the
(^6) John Maynard Keynes, The General Theory of Employment, Interest, and Money
(New York: Harcourt, Brace and Company, 1936).
(^7) See Keith Brown, W. Van Harlow, and Seha M. Tinic, “Risk Aversion, Uncertain
Information, and Market Efficiency,” Journal of Financial Economics 22 (1988):
355–386.
(^8) See Werner F. DeBondt and Richard Thaler, “Does the Stock Market Overreact?”
Journal of Finance 40 (1985): 793–805.
taBle 15.2 Statistical Significance and Economic Profits
Correlation
Coefficienta t-Valueb
Annual Excess
Return (%)
Annual Standard
Deviation (%)
Information
Ratio
0.10 2.10b 0.50 2.17 0.230
0.25 3.78b 1.82 4.06 0.448
0.50 7.15b 3.71 4.25 0.873
0.15 1.20 0.58 1.10 0.527
0.35 2.93b 1.98 4.55 0.435
0.60 2.75b 3.80 4.55 0.835
a Significant at the 1% level.
b t-value is for the significance of correlation coefficient.
Source: Christopher K. Ma, “How Many Factors Do You Need?” Research Paper
#96-4, KCM Asset Management, Inc., 2010.