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.
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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is registered as an investment adviser with the U.S. Securities and Exchange Commission (“SEC”) with its primary place of business in the state of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. References to registration with the SEC do not imply any endorsement or approval of the qualifications of the firm, nor do they imply that the firm’s representatives have attained a particular level of skill or training. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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