Working Paper: NBER ID: w26493
Authors: Alexander M. Chinco; Andreas Neuhierl; Michael Weber
Abstract: The academic literature literally contains hundreds of variables that seem to predict the cross-section of expected returns. This so-called "anomaly zoo" has caused many to question whether researchers are using the right tests of statistical significance. But, here's the thing: even if researchers use the right tests, they will still draw the wrong conclusions from their econometric analyses if they start out with the wrong priors---i.e., if they start out with incorrect beliefs about the ex ante probability of encountering a tradable anomaly. \nSo, what are the right priors? What is the correct anomaly base rate?\nWe develop a first way to estimate the anomaly base rate by combining two key insights: 1) Empirical-Bayes methods capture the implicit process by which researchers form priors based on their past experience with other variables in the anomaly zoo. 2) Under certain conditions, there is a one-to-one mapping between these prior beliefs and the best-fit tuning parameter in a penalized regression. We study trading-strategy performance to verify our estimation results. If you trade on two variables with similar one-month-ahead return forecasts in different anomaly-base-rate regimes (low vs. high), the variable in the low base-rate regime consistently underperforms the otherwise identical variable in the high base-rate regime.
Keywords: Anomaly Base Rate; Empirical-Bayes; Asset Pricing; Predictability
JEL Codes: C12; C52; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| anomaly base rate (D80) | performance of trading strategies (G17) |
| low anomaly base rate regime (D80) | underperformance of trading strategies (G17) |
| high anomaly base rate regime (C46) | performance of trading strategies (G17) |
| empirical-Bayes methods (C11) | estimation of anomaly base rate (C51) |
| historical experiences with predictors (C52) | prior beliefs about anomalies (D80) |
| prior beliefs (D80) | likelihood of identifying tradable anomalies (G14) |
| prior beliefs (D80) | overestimating likelihood of a variable being a tradable anomaly (D80) |