One of the things that makes the COVID-19 pandemic so challenging is false negatives. Early in the pandemic, it was clear that the consequences of infection are more severe for older people, a group my wife and I were surprised to discover includes us. We also learned that most infected people do not show symptoms until two to five days after they are contagious. Because anyone we encountered might be contagious—despite feeling and appearing perfectly healthy—and because the consequences of infection could be so great, my wife and I isolated ourselves from others for about a year. In other words, from the start of the pandemic until we were vaccinated, we avoided false negatives by acting as if everyone else was positive.
The challenge for investors choosing a portfolio strategy is the reverse. Many patterns that look important in realized returns just happen by chance, telling us nothing about future investment opportunities. Although less extreme than the risk of false negatives in the pandemic, false positives in realized returns can have a big impact on your financial health—lowering your expected return while they cause you to pay more expenses and take more risk. As in the pandemic, the solution is to change the default. Assume no return pattern or factor is real until you have compelling reasons to believe it is.
What reasons would be compelling? First, strong statistical evidence, with persistent and consistent differences in average returns across time, markets, assets, and portfolios. Ideally, much of the evidence is out of sample, not just a repackaging of the returns used to identify the pattern or factor.
Evidence of excessive search should undermine your confidence in the pattern. Remember, academics and money managers have strong incentives to identify new patterns. Be suspicious when they use strange definitions or unusual combinations of variables to isolate the pattern, especially if the return premium weakens with a more standard approach.
Strong economic logic is the most important reason to believe a return pattern will persist. Ideally, a model predicts a pattern before it is observed in the data. Usually, however, it’s data first, then the story, so be skeptical. If it looks like the model was cooked up to explain the pattern, it probably was. Don’t believe the story unless the model is truly compelling.
The value effect illustrates these ideas. The first paper Gene Fama and I wrote on the value effect was published in 1992 and used US data from July 1963 to June 1991. We find that book to market equity and earnings to price ratios have a strong positive relation with future stock returns, and average returns increase systematically across portfolios when we sort on these ratios. Fama and I worked with Jim Davis on a paper that finds a similar relation between book to market and average stock returns in the US from 1926 to 1963. We and other researchers also find a strong value effect in developed markets outside the US and in emerging markets. Finally, although the last 10 or 15 years have not been kind to value in the US, in the full out-of-sample period from 1991 to 2020, value outperforms growth by 1%. Reinforcing this broad evidence, other researchers have found a value effect in bonds, commodities, and currencies.
Is there excessive search? Gene Fama and I have stuck with the measure of value we started with in 1991, the ratio of book equity to market equity. The only changes we have made are small adjustments to book equity to accommodate revisions in the accounting rules firms must follow. Other researchers use other definitions, but almost all use some sensible measure of a fundamental, such as earnings or cash flow, divided by price. I do wonder, however, whether a few more-recent changes researchers use are driven more by the returns they produce in-sample than by compelling economic arguments.
The economic logic for the value effect is strong. The driver is price. Stocks with high long-term expected returns or, equivalently, high long-term discount rates must have a low price relative to their expected cash flows. If fundamentals like book equity and earnings proxy for expected cash flows, value stocks, with high ratios of fundamental to price, are likely to have higher average returns than growth stocks, with low fundamental to price.
In short, the value effect is on a solid foundation, with much long-term empirical evidence, robust and complementary measures of value vs. growth, and a simple economic story. Be skeptical of patterns that lack this foundation. Presume they happened by chance, and don’t change your portfolio until you have compelling reasons to believe a pattern in past returns predicts future returns.
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
Ken French and Eugene Fama and are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.
UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
CANADA: These materials have been prepared by Dimensional Fund Advisors Canada ULC. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.
AUSTRALIA and NEW ZEALAND: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.
WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED OR DIMENSIONAL FUND ADVISORS LTD. Neither Dimensional Ireland Limited (DIL) nor Dimensional Fund Advisors Ltd. (DFAL), as applicable (each an “Issuing Entity,” as the context requires), give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.
NOTICE TO INVESTORS IN SWITZERLAND: This is an advertising document.
WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED Issued by Dimensional Ireland Limited (DIL), with registered office 10 Earlsfort Terrace, Dublin 2, D02 T380, Ireland. DIL is regulated by the Central Bank of Ireland (Registration No. C185067). Information and opinions presented in this material have been obtained or derived from sources believed by DIL to be reliable, and DIL has reasonable grounds to believe that all factual information herein is true as at the date of this document.
DIL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DIL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.
WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD. Issued by Dimensional Fund Advisors Ltd. (DFAL), 20 Triton Street, Regent’s Place, London, NW1 3BF. DFAL is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by DFAL to be reliable, and DFAL has reasonable grounds to believe that all factual information herein is true as at the date of this document.
DFAL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DFAL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.
RISKS Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
JAPAN Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.
Dimensional Japan Ltd. Director of Kanto Local Finance Bureau (FIBO) No. 2683 Membership: Japan Investment Advisers Association
FOR PROFESSIONAL INVESTORS IN HONG KONG. This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice.
Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.
SINGAPORE This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.
This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.
False Negatives and False Positives
One of the things that makes the COVID-19 pandemic so challenging is false negatives. Early in the pandemic, it was clear that the consequences of infection are more severe for older people, a group my wife and I were surprised to discover includes us. We also learned that most infected people do not show symptoms until two to five days after they are contagious. Because anyone we encountered might be contagious—despite feeling and appearing perfectly healthy—and because the consequences of infection could be so great, my wife and I isolated ourselves from others for about a year. In other words, from the start of the pandemic until we were vaccinated, we avoided false negatives by acting as if everyone else was positive.
The challenge for investors choosing a portfolio strategy is the reverse. Many patterns that look important in realized returns just happen by chance, telling us nothing about future investment opportunities. Although less extreme than the risk of false negatives in the pandemic, false positives in realized returns can have a big impact on your financial health—lowering your expected return while they cause you to pay more expenses and take more risk. As in the pandemic, the solution is to change the default. Assume no return pattern or factor is real until you have compelling reasons to believe it is.
What reasons would be compelling? First, strong statistical evidence, with persistent and consistent differences in average returns across time, markets, assets, and portfolios. Ideally, much of the evidence is out of sample, not just a repackaging of the returns used to identify the pattern or factor.
Evidence of excessive search should undermine your confidence in the pattern. Remember, academics and money managers have strong incentives to identify new patterns. Be suspicious when they use strange definitions or unusual combinations of variables to isolate the pattern, especially if the return premium weakens with a more standard approach.
Strong economic logic is the most important reason to believe a return pattern will persist. Ideally, a model predicts a pattern before it is observed in the data. Usually, however, it’s data first, then the story, so be skeptical. If it looks like the model was cooked up to explain the pattern, it probably was. Don’t believe the story unless the model is truly compelling.
The value effect illustrates these ideas. The first paper Gene Fama and I wrote on the value effect was published in 1992 and used US data from July 1963 to June 1991. We find that book to market equity and earnings to price ratios have a strong positive relation with future stock returns, and average returns increase systematically across portfolios when we sort on these ratios. Fama and I worked with Jim Davis on a paper that finds a similar relation between book to market and average stock returns in the US from 1926 to 1963. We and other researchers also find a strong value effect in developed markets outside the US and in emerging markets. Finally, although the last 10 or 15 years have not been kind to value in the US, in the full out-of-sample period from 1991 to 2020, value outperforms growth by 1%. Reinforcing this broad evidence, other researchers have found a value effect in bonds, commodities, and currencies.
Is there excessive search? Gene Fama and I have stuck with the measure of value we started with in 1991, the ratio of book equity to market equity. The only changes we have made are small adjustments to book equity to accommodate revisions in the accounting rules firms must follow. Other researchers use other definitions, but almost all use some sensible measure of a fundamental, such as earnings or cash flow, divided by price. I do wonder, however, whether a few more-recent changes researchers use are driven more by the returns they produce in-sample than by compelling economic arguments.
The economic logic for the value effect is strong. The driver is price. Stocks with high long-term expected returns or, equivalently, high long-term discount rates must have a low price relative to their expected cash flows. If fundamentals like book equity and earnings proxy for expected cash flows, value stocks, with high ratios of fundamental to price, are likely to have higher average returns than growth stocks, with low fundamental to price.
In short, the value effect is on a solid foundation, with much long-term empirical evidence, robust and complementary measures of value vs. growth, and a simple economic story. Be skeptical of patterns that lack this foundation. Presume they happened by chance, and don’t change your portfolio until you have compelling reasons to believe a pattern in past returns predicts future returns.
The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized copying, reproducing, duplicating, or transmitting of this document are strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd., Dimensional Japan Ltd., and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
Ken French and Eugene Fama and are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP.
UNITED STATES: Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
CANADA: These materials have been prepared by Dimensional Fund Advisors Canada ULC. Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Unless otherwise noted, any indicated total rates of return reflect the historical annual compounded total returns, including changes in share or unit value and reinvestment of all dividends or other distributions, and do not take into account sales, redemption, distribution, or optional charges or income taxes payable by any security holder that would have reduced returns. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.
AUSTRALIA and NEW ZEALAND: This material is issued by DFA Australia Limited (AFS License No. 238093, ABN 46 065 937 671). This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. Any opinions expressed in this material reflect our judgement at the date of publication and are subject to change.
WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED OR DIMENSIONAL FUND ADVISORS LTD.
Neither Dimensional Ireland Limited (DIL) nor Dimensional Fund Advisors Ltd. (DFAL), as applicable (each an “Issuing Entity,” as the context requires), give financial advice. You are responsible for deciding whether an investment is suitable for your personal circumstances, and we recommend that a financial adviser helps you with that decision.
NOTICE TO INVESTORS IN SWITZERLAND: This is an advertising document.
WHERE ISSUED BY DIMENSIONAL IRELAND LIMITED
Issued by Dimensional Ireland Limited (DIL), with registered office 10 Earlsfort Terrace, Dublin 2, D02 T380, Ireland. DIL is regulated by the Central Bank of Ireland (Registration No. C185067). Information and opinions presented in this material have been obtained or derived from sources believed by DIL to be reliable, and DIL has reasonable grounds to believe that all factual information herein is true as at the date of this document.
DIL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DIL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.
WHERE ISSUED BY DIMENSIONAL FUND ADVISORS LTD.
Issued by Dimensional Fund Advisors Ltd. (DFAL), 20 Triton Street, Regent’s Place, London, NW1 3BF. DFAL is authorised and regulated by the Financial Conduct Authority (FCA). Information and opinions presented in this material have been obtained or derived from sources believed by DFAL to be reliable, and DFAL has reasonable grounds to believe that all factual information herein is true as at the date of this document.
DFAL issues information and materials in English and may also issue information and materials in certain other languages. The recipient’s continued acceptance of information and materials from DFAL will constitute the recipient’s consent to be provided with such information and materials, where relevant, in more than one language.
RISKS
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
JAPAN
Provided for institutional investors only. This document is deemed to be issued by Dimensional Japan Ltd., which is regulated by the Financial Services Agency of Japan and is registered as a Financial Instruments Firm conducting Investment Management Business and Investment Advisory and Agency Business. This material is solely for informational purposes only and shall not constitute an offer to sell or the solicitation to buy securities or enter into investment advisory contracts. The material in this article and any content contained herein may not be reproduced, copied, modified, transferred, disclosed, or used in any way not expressly permitted by Dimensional Japan Ltd. in writing. All expressions of opinion are subject to change without notice.
Dimensional Japan Ltd.
Director of Kanto Local Finance Bureau (FIBO) No. 2683
Membership: Japan Investment Advisers Association
FOR PROFESSIONAL INVESTORS IN HONG KONG.
This material is deemed to be issued by Dimensional Hong Kong Limited (CE No. BJE760) (“Dimensional Hong Kong”), which is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
This material should only be provided to “professional investors” (as defined in the Securities and Futures Ordinance [Chapter 571 of the Laws of Hong Kong] and its subsidiary legislation) and is not for use with the public. This material is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence, or otherwise) the publication or availability of this material are prohibited or which would subject Dimensional Hong Kong (including its affiliates) or any of Dimensional Hong Kong’s products or services to any registration, licensing, or other such legal requirements within such jurisdiction or country. When provided to prospective investors, this material forms part of, and must be provided together with, applicable fund offering materials. This material must not be provided to prospective investors on a standalone basis. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice.
Unauthorized copying, reproducing, duplicating, or transmitting of this material are prohibited. This material and the distribution of this material are not intended to constitute and do not constitute an offer or an invitation to offer to the Hong Kong public to acquire, dispose of, subscribe for, or underwrite any securities, structured products, or related financial products or instruments nor investment advice thereto. Any opinions and views expressed herein are subject to change. Neither Dimensional Hong Kong nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors. Financial advisors in Hong Kong shall not actively market the services of Dimensional Hong Kong or its affiliates to the Hong Kong public.
SINGAPORE
This material is deemed to be issued by Dimensional Fund Advisors Pte. Ltd., which is regulated by the Monetary Authority of Singapore and holds a capital markets services license for fund management.
This advertisement has not been reviewed by the Monetary Authority of Singapore. This information should not be considered investment advice or an offer of any security for sale. All information is given in good faith without any warranty and is not intended to provide professional, investment, or any other type of advice or recommendation and does not take into account the particular investment objectives, financial situation, or needs of individual recipients. Before acting on any information in this material, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Dimensional Fund Advisors Pte. Ltd. does not accept any responsibility and cannot be held liable for any person’s use of or reliance on the information and opinions contained herein. Neither Dimensional Fund Advisors Pte. Ltd. nor its affiliates shall be responsible or held responsible for any content prepared by financial advisors.
06/23/2021
https://my.dimensional.com/false-negatives-and-false-positives
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