Something called “the Selection Bias”!!

The (GREAT) Efficient Market Hypothesis does not exactly arouse enthusiasm in the community of investment practitioners alias professional portfolio managers. In other words, it is said that a great deal of their activities i.e. the search for undervalued securities is at best wasted efforts, and quite probably harmful to their clients (HNIs, small & retail investors and so on) because it costs money and leads to imperfectly diversified portfolios. Such practices lead to the debate of whether EMH is valid at all? I would say “NO”. In support of this opinion, I would discuss about a factor called “selection bias” among other factors that support this view of inefficiency of stock markets.

Suppose that an investment analyst discover an investment scheme that could really make money out of stocks. (S)he has two choices: either publish his/her technique in financial press such as the Wall Street Journal, the Economic Times, the Business Line and so on (in print media), the ET Now,  the NDTV Profit and so on (in e-media) and win fleeting fame; or keep his/her secret technique secret and use it to earn millions  of Rupees. Most investors/analysts would choose the second option (Obviously!! Isn’t it?), which present us with a conundrum.

Only investors/analysts who find that an investment scheme cannot guarantee abnormal returns will be willing to report their findings to others. Hence the notion of Efficient Market Hypothesis (EMH) is doomed here only. It is evident that successful investment strategies are not being reported to the public, only those which do not provide investment rewards are available to the mass investors. This is a problem in “selection bias“; the outcome we are able to observe have been preselected in favour of failed attempts. Therefore, we cannot fairly evaluate the true ability of portfolio managers to generate winning stock market strategies.

 

Adapted from: Investments (BKM), 7th ed.

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